Table of contents (Part 3)
Voluntary administrators of SMEs
19. Why do SMEs appoint voluntary administrators?
20. What is the downside of voluntary administration?
21. Why is a voluntary administration impractical for a microbusiness (1-4 employees)?
22. Are insolvency practitioners under a conflict of interest when advising on a pre-pack voluntary administration?
Restructuring of SMEs
23. What does the law consider to be phoenix activity?
24. When can an insolvent business be transferred to a related entity?
25. How does Fair Entitlement Guarantee treat employees when a business is transferred?
26. What does the licensing of a business mean?
27. What types of finance are available for a pre-pack insolvency arrangement?
28. Why are pre-pack insolvency arrangements common-place restructuring transactions in the UK but not in Australia?
29. What standards of valuations do courts expect for a pre-pack insolvency arrangement?
30. Are pre-pack insolvency arrangements possible if there are secured creditors?
31. What operational improvements can result from a pre-pack insolvency arrangement?
32. Are pre-pack arrangements possible if premises and/or plant and equipment are all leased?
33. What do the courts regard as a sham or fraudulent transaction?
VOLUNTARY ADMINISTRATORS OF SMES
1. Why do SMEs appoint voluntary administrators?
The voluntary administration regime was intended to create a statutory mechanism to turnaround an insolvent business under the supervision of an insolvency practitioner. It is the principal legal mechanism for dealing with insolvency and giving insolvent SMEs breathing space to persuade creditors to accept a compromise.
However, judging the success of the voluntary administration regime is problematic because:
- There is very little empirical research into voluntary administration; and
- The research that is available does not support the proposition that voluntary administration succeeds in the majority of cases.
It is a reasonable hypothesis that when directors appoint voluntary administrators they may be unwittingly opening a “pandora’s box” without considering the risk.
A 1998 Australian Securities Commission (ASC) research paper reported the outcomes of empirical research into the reasons that directors appointed a voluntary administrator . The study found that of 55 voluntary administrations the motivation behind the appointment of an administrator included:
- To restructure (33%), as there was a problem with the financial, management or legal structure of business that could be altered by voluntary administration.
- To avoid consequences of liquidation (20%). However, this may have been to avoid the consequences of an insolvent trading claim or the recovery of a voidable transaction.
- To facilitate a liquidation (20%). This may be part of a strategy to delay liquidation and, for example, may be to facilitate an asset sale while the business trades under administration (i.e. a pre-pack arrangement).
- To avoid directors’ liability for withholding company tax (7%). This is likely to have altered with the introduction of director penalty notices and automatic liability for specific taxation liabilities. It is likely to be a more important consideration today.
Academic writer, Eow (2006) considered the question of whether voluntary administration was an enabler of strategic behaviour or abuse, and identified 6 principal motivations of business owners and directors when commencing the voluntary administration process. Eow analysed the motivations behind the appointment of a voluntary administrator and found that the motivations were contrary to the intentions of policy makers.
The 6 principal motivations were:
- Delay creditors: Using the process to delay creditor action;
- Litigation tactic: Staying winding up applications or other causes of action being litigated;
- Director’s escape valve: Avoiding investigations that may follow a liquidation;
- Control of the company: Resolution of internal disputes between directors/ business owners;
- Employees: Stifling enterprise bargaining/employment disputes;
- Future complaints: Avoid compensating future claimants by staying contingent claims;
- Relation-back period deferred: Deferring the start of relation back period if a winding up application is filed.
The above is a list of the challenges that the voluntary administration regime may tactically deliver. From an insolvency lawyer’s point of view there is a critical difference between motivations that are against policy and motivations that are illegal. There is no suggestion that the above motivations are illegal, and accordingly these tactics are being utilised by pre-insolvency advisors regularly. There may however be good practical reasons to avoid a voluntary administration, it may fail to deliver a debt free business with harmonious employee and supplier relationships after it has completed.
2. What is the downside of voluntary administration?
There are numerous downsides to the voluntary administration regime for directors of SME’s. These include costs, publicity, loss of control, termination of supplier and customer relationships and the “Black Swan” event.
Costs of Voluntary Administration
When a voluntary administrator is appointed to a company they are entitled to recover their fees from the company in administration. Ultimately, these fees need to be approved by the creditors or by the court and this is outside of the control of the directors. While the exact cost of a voluntary administration will vary depending on the circumstances of the company in administration, there are a number of tasks which an administrator is required by the Act to carry out.
- Notifying ASIC of the administration (r 5.3A.03 Corporations Regulations 2001);
- Issuing notices to creditors (s439A);
- Conducting the first meeting of creditors (s436E);
- Dealing with creditor’s enquiries (s437A);
- Investigating the affairs of the company and forming an opinion on the best course of action for the company (S438A);
- Preliminary Investigations into whether there are any transactions that would be voidable transactions in a liquidation (r5.3A.02 Corporations Regulations 2001);
- Reporting any suspected misconduct by directors to ASIC (S438D);
- Preparing and issuing a detailed report to creditors (S439A);
- Conducting the second meeting of creditors (S439A, S439B); and
- Notifying ASIC of the outcome of the second meeting of creditors (r 5.3A.01 Corporations Regulations 2001).
In a typical voluntary administration an administrator may also need to carry out tasks not specifically prescribed by statute, such as:
- Trading the business;
- Dealing with secured creditors;
- Dealing with finance customers and suppliers;
- Dealing with employees
- Collecting and selling assets of the company;
- Detailed investigations into potential recoveries and asset ownership.
The costs of the administrator are charged at an hourly rate, broken down into 6 minute units. These fees are approved by creditors at the first and second meeting of creditors. If the company decides to enter into a deed of company arrangement, the company will remain under the supervision of a deed administrator (normally the voluntary administrator) and further costs will be incurred, with no guarantee the business will survive. ASIC has reported that of the 5760 companies that entered into voluntary administration between 1993 and 1997, only 10% resumed normal trading at the conclusion of the process.
There is very little empirical research on the success rates of voluntary administration that can contradict this 10% finding.
The costs of a voluntary administration for a SME are likely compared to the engagement of other professionals such as bookkeepers, IT consultants, engineers etc. The economic reason for high pricing is the personal trading risk administrators assume (they pay for any shortfalls in trading receipts) and that some appointments taken do not sufficiently pay the appointers fees. To compensate for this the appointers charge heavily when they have a job that is fully funded. There is also (largely anecdotal evidence) a view that insolvency practitioners are too numerous, or alternatively that there are too few jobs to support them.
Within three days of taking an appointment, administrators are required to publish a notice of their appointment as administrator of the company. This means that all creditors, as well as the public, will become aware that the business is insolvent and this will reduce the chance that the business may be able to continue to viably trade.
The consequences of all the suppliers, customers and employees being on notice that the company is insolvent are difficult to predict. In the Geon Group liquidation (a commercial printer business) the paper suppliers combined to refuse to supply any stock to the administrators and they were forced to close the business.
Loss of Control
Sections 437A and 437C of the Act require that upon the appointment of the administrator, control of the company passes from the directors to the administrator, once this has occurred the directors must not act without the consent of the administrator. This means that the control of the company is taken over by an accountant who specialises in insolvency rather than a person with knowledge of the business and its markets. There is no guarantee that the administrator will have knowledge of the industry in which the company operates or have the management skills necessary to ensure the survival of the business. In the alternative, it is likely that they do not.
There are often undertakings or understandings regarding how an administrator will conduct business. Any such undertakings are unenforceable by law and further there is no guarantee that the business will continue to trade and not be closed. This is a judgment call of the administrator.
The process of voluntary administration involves two meetings of creditors, required by sections 436E and 439A of the Act. At the second meeting of creditors the creditors vote on whether to go ahead with the reorganisation of the company proposed by the directors. The ultimate question as to whether or not the business can trade on or be sold as a going concern is thus in the hands of the company’s creditors, but the voluntary administrator has the reins of the company from the date of their appointment.
It is within the power of the administrator to sell the business assets before the second meeting of creditors, but they usually do not want to do this because it may expose them to criticism from creditors. It is unlikely, due to time constraints, that the administrator will be able to offer the business assets for public sale, complete their report and prepare a comprehensive report to creditors before convening the second meeting. To avoid this the administrator often licences business assets to directors upon appointment.
Ipso Facto Clauses
Properly drafted commercial contracts often include a provision called an ipso facto clause. An ipso facto clause provides that upon an ‘insolvency event’ occurring, the solvent party has the right to terminate the contract. A company entering into voluntary administration falls within the definition of an ‘insolvency event’.
When a company enters into voluntary administration, their suppliers, customers, landlords and financiers frequently make use of the ipso facto clause to terminate their contracts and call in their debt irrespective of payment terms. A flight of suppliers and customers may force the company to cease trading, meaning that any proposal for a compromise becomes academic because it is impractical to continue trading.
This means that voluntary administrations over retail premises, franchisers and distributors are not usually recommended.
The Government is currently proposing to introduce legislation which would make ipso facto clauses unenforceable if a company is undertaking a restructure. This will mean that if a company is undertaking a restructure under an administration, then an ipso facto clause will become temporarily unenforceable during voluntary administration.
Black Swan Event
A Black Swan event, in finance, is an event or occurrence that deviates from what is normally expected and it is extremely difficult to forecast. The appointment of a voluntary administrator opens a ‘pandora’s box’. A business is taken over by a qualified advisor, suppliers and customers are then informed of the company’s insolvency and invited to vote and decide upon the future of the company, at this stage employees are given a strong signal that the future prospects of the company are limited. In this scenario of conflicting interests unpredictable outcomes are foreseeable but not easily foreseeable at the start of the process.
3. Why is a voluntary administration impractical for a microbusiness?
The key issues with appointing a voluntary administrator over a microbusiness (being a business with 1-4 employees) are:
- It may be overkill because debt issues could possibly be resolved informally;
- Many businesses in this category trade as sole traders or partnerships and voluntary administration does not apply to unincorporated businesses;
- The costs may outweigh any economic benefit; and
- There may be other tactics such as a transfer to related parties that may be a more efficient tactic.
The voluntary administration process involves two meetings of creditors, investigations by an insolvency practitioner and the involvement a variety of other professionals including valuers, auctioneers, lawyers and IT advisors.
If there are a small number of creditors and there appears to be a straight-forward root cause for the insolvency challenge the involvement of all the stakeholders and professionals may become counterproductive. Simple and straightforward negotiations with creditors, suppliers and staff may be sufficient to negotiate a compromised solution for microbusinesses to avoid a formal appointment.
Many microbusinesses trade as sole traders or in partnerships and therefore a voluntary administration is not applicable because it applies only to companies.
Further, there is only a temporary protection in voluntary administration to stop the enforcement of personal guarantees and therefore even if a compromise is entered into (i.e. a deed of company arrangement) this will not stop creditors from enforcing personal guarantees after the voluntary administration process is completed. This is important for small businesses because suppliers and financiers often request personal guarantees from directors and therefore the deliverable of a deed of company arrangement may be hollow if the directors are called on to pay the shortfall once the deed has been effectuated.
Costs too high
There is very little empirical research into the professional costs of voluntary administration, however, it would be accurate to point out that the costs are increasing. Since voluntary administration commenced in 1993 the complexity of the process has increased and the input costs of the professional firms (i.e. staff, IT, disbursements, lawyers etc.) has also dramatically increased.
It would be surprising if an insolvency practitioner was prepared to take an appointment for less than $40,000 making this a costly expedition for a microbusiness. If a practitioner were to take on the appointment for less than this amount they would be at liberty to apply for further costs to be approved from creditors and therefore any pre-appointment undertaking is reversible.
Other tactics may be more efficient
If a micro-business has no intellectual property, and only a handful of contracts and personal relationships with customers that drive business and revenues based upon the skills of the proprietors, there may not be any commercial or legal reason to spend the funds to appoint a voluntary administrator to protect the trading entity (i.e. the corporate shell).
It may be in the interests of the directors to consider whether to appoint a liquidator and continue trading through another business entity. The methodology of a pre-pack insolvency arrangement may be a suitable instrument but legal and accounting advice should be sought before considering it as an alternative to voluntarily administration for business rescue.
4. Are insolvency practitioners under a conflict of interest when advising on a pre-pack voluntary administration?
A conflict of interest arises when the interest of the insolvency practitioner diverts from their client. When providing professional advice consultants take a fiduciary duty at law to not prefer their interests to their client’s interests.
Insolvency practitioners can also put themselves into a position of conflict where they take on an insolvency appointment and they have a statutory obligation to investigate the product of their own advice (i.e. a pre-pack insolvency arrangement).
The risk in taking advice from an insolvency practitioner is that if they are subsequently appointed as voluntary administrator they will be in breach of their professional obligations. The ARITA professional code requires insolvency practitioners to refuse an appointment where they have had a significant professional relationship in the previous two years.
It is unlikely that an insolvency practitioner would prefer to provide ad hoc advice than take an appointment as voluntary administrator because of the substantial professional fees that they would earn through a voluntary administration.
It is recommended that any advice is subject to strict confidentiality and that in the event there are problematic transactions that a lawyer be engaged to ensure legal professional privilege applies.
RESTRUCTURING OF SMES
23. What does the law consider to be phoenix activity?
There is no legal definition of phoenix activity (also known as phoenix arrangements) in the Act or in any other legislation.
The Department of Treasury defines phoenix activity as:
“The evasion of tax through the deliberate, systematic and sometimes cyclic liquidation of related corporate trading entities.”
While it is not specifically defined in statute, the sale of a business will constitute phoenix activity when:
- Oldco is insolvent;
- Oldco’s business is transferred for inadequate payment to Newco;
- This transaction is detrimental to creditors, employees and other stakeholders; and (often)
- There is a cyclical element because it is repeated.
The term “phoenix activity” has a long history. The “Bottom of the Harbour” schemes attracted attention from the ATO in the 1970s and 1980s. These schemes were promoted by lawyers and accountants to help entrepreneurs strip assets and profits from companies, leaving the ATO and other creditors stranded without any recourse in pursuit of debts.
The “Bottom of the Harbour” schemes led the Federal Government to introduce the Crimes (Taxation Offences) Act 1980 (Cth). This statute makes it a criminal offence to enter into an arrangement with the intention of creating an arrangement to cause a company to be unable to pay taxes, such as income tax and the superannuation guarantee charge. The statute also extends criminal liability to advisors who assist others in entering into such arrangements. The penalty can be up to ten years in jail and a fine of up to $180,000. The court can also order that an individual be liable to pay the outstanding tax liabilities. While we have found no recent case law where anyone has been charged under this statute, it is important for directors and their advisors to be aware of it. It is possible that the failure to prosecute under this statute stems from the difficulty to prove beyond a reasonable doubt that there was an intention to avoid payment of taxes and debts.
Phoenix activity is also known as asset stripping because it involves expropriating all useful assets from a company for a low price or as part of a sham transaction. Research carried out by the ASC in 1996 found that 18% of SMEs had been adversely exposed to phoenix company activity. For most companies this would be as a result of being an unpaid creditor to a company which undertook phoenix activity.
Phoenix activity occurs for a broad range of reasons:
- Directors might be pocketing funds to pay for a lifestyle that drains the business;
- Businesses having unsustainable business models;
- In a dishonest attempt to evade a company’s debts; or
- It may be an attempt at disaster recovery.
Liquidators have the power under the Act to apply to the court to claw back assets or value in certain transactions. Liquidators are under no obligation however to take this action if they have no funds to pay for legal action.
The phoenix operator’s model in the past has been to appoint their preferred liquidator after the assets of a business are transferred out of the company, leaving an empty shell. The liquidator is paid a fee that would cover basic work but nothing beyond this and so the liquidator is forced to seek funds from the creditors. The phoenix operators are confident that creditors will not fund the liquidator (i.e. and “throw good money after bad”) and therefore the asset transfers will not be challenged. There is also an understanding that if a liquidator were to pursue the phoenix activity vigorously they may prejudice themselves for future appointments.
Part 5.4C of the Act was introduced in 2011 and its stated aim is to eradicate phoenix activity. Part 5.4C of the Act gives ASIC the power to appoint a liquidator to a company which it believes to be abandoned. This means, that where a business has been phoenixed, and no creditors have taken action to appoint a liquidator, ASIC can appoint a liquidator without needing to apply to the court. The purpose of the liquidator is to then uncover breaches of the law occurring as a result of the phoenix activity and take legal action. However, if the liquidator is appointed to an asset less administration they will undertake a cost/benefit assessment before taking action. If the costs/benefit analysis (i.e. the recoverability of fees) is unfavourable they will be unlikely to proceed with action. Further, there is no empirical evidence to suggest that ASIC has used this power to wind up SMEs at all.
A report from Melbourne Law School called ‘Defining and Profiling Phoenix Activity” outlines a history of definitions of phoenix activity. The report demonstrates that the definition of phoenix activity is amorphous and that there is no accepted definition at law. The report concludes that there is a difference between certain types of phoenix activity. The report differentiates the types of phoenix activity that are illegal, and types that may be considered legal, and discusses the relevance of a determination based on the intention behind the activity. The report states:
“The behaviour becomes illegal where the intention of the company’s controllers is to use the company’s failure as a device to avoid paying Oldco’s creditors that which they otherwise would have received had the company’s assets been properly dealt with.”
The report separates phoenix activity into five categories, categorising them into activities that should be considered legal phoenix activity, or business rescues, and those that should be categorised as illegal phoenix activity.
The categories of phoenix activities identified by the report are:
- Legal phoenix or business rescue
The best example of this is a business owner whose business was damaged by a flood. An unpredictable event that devastated the business but the underlying business is viable and the owner wants to continue to use the business name, goodwill, client list, intellectual property, etc. In this scenario a transfer is legal if it does not fall foul of the laws relating to uncommercial transactions and breach of directors duties. For a transaction to be considered a legal phoenix any transfer must be for adequate consideration.
The academics emphasise that in this scenario there is no intention to avoid paying creditors and it is beneficial economically because a viable business can be rescued.
- The problematic phoenix
An example of this is a person with poor business skills continuing an uneconomic business. This type of phoenix activity is argued to be technically legal because there is no intention to defraud creditors. It is also legal because it involves a transfer for adequate consideration so it does not contravene the Act. In the writer’s opinion, this scenario is problematic because the resurrection is not beneficial to the economy.
- Illegal phoenix 1: Intention to avoid debts formed as the company begins to fail
There is an intention to defraud creditors, which involves the transfer of assets for a below value price. This intention is usually formed after the business becomes insolvent.
- Illegal phoenix 2: Phoenix as a business model
This scenario is where a company is deliberately set up to be phoenixed. From the inception of the company its primary intention was to be phoenixed. In the building and construction industry there have been labour hire subsidiaries that are liquidated to avoid tax and employee entitlements that fit within this category. This leads to economic consequences, because it gives the phoenix operators an unfair competitive advantage, while forcing employees to be reliant on the government for payment of entitlements.
- Complex illegal phoenix activity
This final category involves a phoenix intention at the inception of the company (i.e. illegal phoenix 2) but with added illegality. One example cited by the report is a case where the directors used false ABNs to confuse the ATO and combined this with cyclical phoenix of tax burdened companies.
24. When can an insolvent business be transferred to a related entity?
There is no specific section of the Act or of any other legislation that prohibits the transfer of an insolvent business to a related entity. There are however, some powers a liquidator has to overturn a sale to a related entity.
If a court finds that the sale amounted to either an uncommercial transaction or an unreasonable director-related transaction the liquidator can have it overturned or have Newco or the directors compensate Oldco for the loss suffered.
An uncommercial transaction is defined as a transaction where it “may be expected that a reasonable person in in the company’s circumstances would not have entered into, having regard to:
- The benefits (if any) to the company on entering into the transaction;
- The detriment to the company of entering into the transaction;
- The respective benefits to other parties to the transactions of entering into it; and
- Any other relevant matter.”
A liquidator has the power to apply to a court to claw back an uncommercial transaction that is also an insolvent transaction that was entered into in the 2 years preceding their appointment as liquidator.
An unreasonable director-related transaction is defined as a transfer of business assets to a director where “it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction”.
A liquidator may apply to a court to overturn an unreasonable director-related transaction if it was entered into in the 4 years prior to the appointment of the liquidator. Unlike with uncommercial transactions, the liquidator does not need to prove that Oldco was insolvent at the time of the director-related transaction.
In order to avoid claw back action from a liquidator the directors need to ensure that any sale of an insolvent business from Oldco to a related entity is for a reasonable price or for adequate consideration.
The Government is currently proposing, as part of its Innovation Reforms, to introduce a safe harbour defence for directors in situations where the director has appointed a pre-insolvency advisor. The safe harbour would protect the director from liability for insolvent trading while the company attempts to restructure. This restructuring could include the sale of the business to a new related entity on commercial terms.
At present, if the sale of the business occurred before the appointment of an administrator or liquidator, the directors could be liable to a subsequently appointed liquidator for insolvent trading.
Due to the issues outlined above it is preferable for any sale of an insolvent business to occur after the appointment of an administrator of liquidator, or to at least be subject to the approval of a later appointed liquidator or administrator. It is also imperative for the directors of the business to ensure that any business transfer is made for a reasonable commercial price.
It is recommended that before transferring assets out of an insolvent company that legal and accounting advice be obtained to ensure that the transaction is not clawed back as either an uncommercial transaction or a director-related transaction.
25. How does the Fair Entitlements Guarantee treat employees when a business is transferred?
The Government in some cases, provides assistance to people who are owed outstanding employee entitlements following the insolvency or bankruptcy of their employer. This help is available through the General Employee Entitlements and Redundancy Scheme (GEERS) if the employer entered liquidation before 5 December 2012 or the Fair Entitlements Guarantee (FEG) if the employer entered liquidation on or after 5 December 2012.
FEG is a legislative scheme set up by the Government to act as a last resort for employees whose employers have become insolvent. Under FEG, employees are paid:
- up to 13 weeks of unpaid wages;
- annual leave;
- long service leave;
- payment in lieu of notice (up to 5 weeks); and
- redundancy pay (up to 4 weeks per full year of service).
Under the Fair Entitlements Guarantee Act 2012, employees must meet all the following requirements to be eligible for assistance under the FEG:
- the person’s employment by a particular employer has ended;
- after the commencement of this law, an insolvency event happened to the employer;
- the end of the employment:
- was due to the insolvency of the employer; or
- occurred less than 6 months before the appointment of an insolvency practitioner for the employer; or
- occurred on or after the appointment of an insolvency practitioner for the employer;
- the person is (or would, apart from the discharge of the bankruptcy of the employer, be) owed one or more debts wholly or partly attributable to all or part of one or more employment entitlements;
- the person has taken steps, so far as reasonable, to prove those debts in the winding up or bankruptcy of the employer;
- if the person was owed any of those debts before the insolvency event happened, the person took reasonable steps before that event to be paid those debts;
- when the employment ended, the person was an Australian citizen or, under the Migration Act 1958, the holder of a permanent visa or a special category visa;
- an effective claim (see section 14) that the person is eligible for the advance has been made to the Secretary by or on behalf of the person.
There are also categories of people that are excluded from eligibility under the FEG scheme including directors and relatives of directors. This means that business owners will be unlikely to utilise FEG.
8. What does the licensing of a business mean?
The concept of licencing is often critical to pre-pack arrangements because it allows a Newco to commence trading a business before an insolvency appointment so that the liquidator or voluntary administrator can ratify a final transfer after their appointment. This is the key foundation of the UK pre-pack regime, although it is not formally recognised in Australia, licencing remains a useful tool.
The licensing of a business occurs when one party (licensor) grants permission for another party (licensee) to use the licensor’s intellectual property rights, plant and equipment, employees, premises and business undertaking conditionally.
Businesses often use licensing as a marketing and brand extension tool to expand their business. In a successful licensing scenario, the business that owns the assets is able to maintain control over brand image and how it is portrayed and in addition, the business receives the benefit of additional revenue in the form of royalties, business exposure in new channels and new opportunities for business expansion. Franchising is a form of business licencing.
A licensing agreement is the document that sets out the terms of the licence. It is a legal contract between two parties, known as the licensor (party leasing the business) and the licensee (party leasing from the licensor). Pursuant to the licensing agreement, the licensor grants the right for the licensee to use the licensor’s property, for example brand name or trademark or the patented technology owned by the licensor, and in exchange the licensee accepts conditions regarding the use of the property and payment for utilisation of the business assets.
At any point during the term of the license, the licensor could become insolvent and an administrator or liquidator appointed. However, when an administrator or a liquidator is appointed to the licensor company it does not give the administrator or liquidator automatic termination of the license, unless provided for under the terms of the license.
If Oldco is put into administration the landlord may recover Oldco’s property by taking possession, by entering into or assuming control of the property, pursuant to section 441F of the Act. The exception to this rule occurs if the property is considered for the purpose of administration under the Deed of Company Arrangement, the court can then order that property is not to be taken into possession. If the lessor takes no action before the administration of the lessee company, under section 440C they cannot take possession of the property, except with the administrator’s written consent or leave by the court. To remedy the issue Newco usually agrees with the landlord to pay current rent during the period of the licence.
The takeaway is that where it is not feasible to transfer all useful business assets before a liquidator or administrator is appointed a licence agreement can provide an immediate solution to ensure business continuity and avoid a liquidation fire sale.
27. What types of finance are available for a pre-pack insolvency?
|Type of Finance||Security||Typical Providers||Typical Interest Rates (range)||Loan Purpose|
|Receivables finance||Purchase of receivables is required. The financier may also require a general security agreement||Niche finance providers and banks||12% on drawn funds, with a further 3% on total invoice value plus other fees and charges
|Promotes cash flow and protects business from delayed payment from debtors. Also outsources collections.|
|Equipment finance||At a minimum security taken out over the relevant equipment||All major banks, as well as various smaller finance providers||Varies depending on risk
|Provides finance for the purchase of new equipment|
|Personal loan||Largely unsecured, dependent on provider, sometimes residential or commercial property or business assets are required||All major banks, as well as various smaller finance providers||(8%-22%)||Provide funds, lent to Director for working capital|
|Credit card||No security required||All major banks||(14%-22%)||Varied|
|Bank overdraft||Dependant on provider, sometimes residential or commercial property or business assets are required||All major banks||(8%-20%)||Gives business a solution to short term liquidity crises|
|Mortgage finance||Residential or commercial property||All major banks||(5%-9%)||Provides funds secured by real property, often residential property|
|P2P Lending||Varies from lender to lender||Think Cats Australia, OnDeck, Marketlend||(8% – 17%)||Connects borrowers with individual lenders through online platform|
|Friends, Fools and Family||Not required||Parents, extended family, friends||N/A||To provide necessary funding to the business|
Receivables finance (also called debtor finance or discounting invoices), is the purchase of a company’s debts that facilitates the company to receive income from their invoices as soon as they are issued, rather than waiting for clients to pay at the end of often long payment cycles. Banks and other lenders who offer receivables finance advance to a company a percentage of the invoice amount after it is issued, alleviating many of the issues that come with poor cash flow. Often receivables financing is attractive to small businesses as there are minor credit requirements on the borrower. A receivables financier will be primarily interested in the quality of the debt that is owed to the business rather than the profitability of the business itself.
Receivables financing can be divided into two separate categories. The first category is not visible to the debtor. In this form the business receiving the finance obtains money from the financier on the presentation of an invoice and the financier decides whether or not to fund the invoices on an individual basis. The invoice is still remitted to the company however, and the company remains responsible for their own collections and for paying back the money to the financier.
The second category is visible to the debtor and the market. This is the form of financing typically provided by smaller finance providers who specialise in receivables finance. The receivables are normally assigned to the financier in their entirety. The financier then advances a percentage of funds (usually 60%-80% of the invoice value) to the borrower against the invoices as they are issued. When the invoice is paid in full the remainder of the funds are paid to the borrower, minus interest and fees. In this category the invoices are actually remitted to the financier with the monies being paid into an account controlled by the financier. Therefore, the financier also takes charge of collections. This style of financing is attractive to businesses wishing to outsource their collections and focus on their core profit making activities.
Receivables finance can also be used for Newco to immediately obtain a sum of money in order to provide consideration for the purchase of Oldco. This will help a director to limit the amount which they may need to provide security for, or borrow in their personal capacity, but it will reduce the ability of Newco to purchase inventory without further funding. Unlike many other forms of finance that may be available, this will not necessarily require Newco to put up any collateral as security, which can be a major advantage. However, as with any type of finance, it does come at a cost, with companies that provide receivables financing generally charging relatively high fees, as well as charging high interest on the amount that is advanced. There are also penalties involved if Newco’s debtors are slow in repayments.
Advantages of Receivable Finance: Improves cash flow, credit checks performed on debtors rather than borrower, No restrictions on what funds are used for
Disadvantages of Receivables Finance: High rate of interest, potentially damage business relationships by having collections conducted by third party
Current Providers of Receivables Finance: Cashflow Finance, Scottish Pacific.
Equipment Finance is finance granted with security taken over a business’s physical assets. As security is provided it generally has a lower interest rate than unsecured borrowing, however it will have a higher rate of interest than borrowings secured by real property. For example, equipment financing could be used to purchase cars for sales representatives, plant or machinery necessary for the production of a business’s product or computers for an office. In a pre-pack scenario Newco could request the novation of the loan to ensure the conveyance of the equipment from Oldco to Newco.
The structure of equipment finance can vary greatly, with some being lease back arrangements where the bank retains title of the purchased equipment, with others having the business retaining title while the bank retains a security interest. Typically the lender will also require the directors to provide personal guarantees in order to secure an equipment finance loan.
Advantages of Equipment Finance: Reduced interest rate as security provided, very useful for purchasing new plant and equipment
Disadvantages of Equipment Finance: Restriction on what money can be used to purchase, personal guarantee
Examples of Current Providers of Equipment Finance: All major banks
A personal loan taken out in the name of a director can be a convenient way to raise money for a business quickly. It can be used in times when cash flow is poor in order to boost funds for the company, and is also potentially a source of funding for the purchase of Newco from Oldco. However, because this loan is taken out in a personal capacity it adds a degree of risk.
Personal loans are also offered by lenders of “last resort”. These loans have very high interest rates, with rates sometime being as high as 55% per annum and often with significant additional fees. Even personal loans from major banks have high interest rates with unsecured personal loans from banks and credit unions having rates ranging from 9% to 22%.
Taking out a personal loan for a business should be avoided if possible as it exposes the company director to the kind of personal liability and financial risk that use of the corporate form is designed to minimise.
Advantages of Personal Loans: Access to funds that are otherwise unavailable and speed
Disadvantages of Personal Loans: High rate of interest, personal liability
Examples of Current Providers of personal loans: All major banks, GE Money, Rate Setter, RACQ, Society One, Various credit unions.
A director’s personal credit card or a credit card in the name of the business can be a source of finance for a business.
Credit Cards are an attractive source of finance as:
- The money provided by a credit card is flexible, there are no limitations by the bank on how the funds can be spent.
- The money is easily accessible, with credit cards being accepted by most suppliers
As credit card interest rates are often around 20% per annum this should be treated as a last option and should not be used for debt that will not be paid off promptly. The interest rate charged is further amplified because credit cards interest compounds monthly. This effect is further multiplied if one card is being used to pay off the interest on another.
Advantages of a Credit Card: No restrictions on what money is used for, money easily accessible.
Disadvantages of a Credit Card: Very High interest rate, Director typically personally liable.
Examples of Current Providers of Credit Cards: All Banks.
A bank overdraft can be an effective way for a business to access finance. An overdraft, like a credit card, gives a business access to a set amount of funds. Rather than being tied to a repayment schedule, as with a personal loan, the business pays interest on funds that are withdrawn at regular dates (i.e. monthly). This has the advantage of allowing the business to keeps their repayments to a minimum during times of stress. As an overdraft is typically continually available, it can be applied for during a time of financial stability, with funds then being available during a short term crisis.
An overdraft is typically attached to a business transaction account. As the facility is offered by a bank the approval process is more onerous than with niche financiers. It is also common for the bank to require the directors of the company to provide personal guarantee’s to secure any amounts borrowed. Interest rates for an overdraft are also relatively high, with rates of around 15% being common where no additional assets have been given as security.
Advantages of a Bank Overdraft: Flexible facility – only borrow the amount needed, always available
Disadvantages of a Bank Overdraft: High rate of interest, personal guarantee
Examples of Current Providers of a Bank Overdraft: All Banks
Inventory finance is financing which is provided to allow a business to purchase their inventory with repayment being made once the product has been sold to the end customer. This kind of finance can be particularly useful when a business is starting up as it can be used to fund the initial purchase of inventory.
Typically with this kind of finance, because the assets will not be staying in the possession of the lender, the financier will require a personal guarantee from the directors of the company.
Advantages of Inventory Finance: Allows for purchase of inventory.
Disadvantages of Inventory Finance: not available to all industries, interest charges accruing during production process.
Examples of current providers of inventory finance: most major Banks, although this often limited to particular industries.
Family, Friends and Fools
Borrowing from friends, family or fools (FFF) is attractive for a number of reasons. The main reason in that FFF’s are unlikely to require security or to charge a high rate of interest. FFF’s are also not in a position to run credit checks or to carry out due diligence on the assets of the business. FFF’s are also unlikely to understand the risks involved in making the proposed loan.
Rather than taking on debt, one strategy is to ask a FFF to invest in the business and in return give them shares. This has the advantage of meaning the business will only need to pay the FFF if it is making a profit and paying a dividend.
However, funding from an FFF is not available to all and may impact adversely on personal relationships if a company faces financial difficulty.
Advantages of Friend, Families and Fools: Low interest, limited credit checks, unlikely to require security.
Disadvantages of Friends, Families and Fools: Potential negative impact on close personal relationships.
Mortgage finance is finance provided in return for security granted over property. Some businesses have sufficient property of their own to secure borrowings, but if a business has limited assets, lenders will often require a mortgage over the real property of the directors. As with a personal loan, this should be avoided if possible as it increases the risk of personal loss to the director if the business is unsuccessful. There is also a danger to the director’s family as their home may be in jeopardy of repossession if the business fails.
There is one very significant advantage of a loan secured by residential property. These loans will generally attract the lowest rates of interest with some finance currently available at interest rates approaching 5% per annum. This rate of interest is very low historically with mortgage interest rates when compared to other forms of finance.
Advantages of Mortgage Finance: Low rate of interest.
Disadvantages of Mortgage Finance: Puts personal assets at risk.
Current providers of Mortgage Finance: All banks.
Peer-to-Peer (P2P) Lending
P2P lending is a new platform for lending that uses online platforms to connect individual non-bank lenders to borrowers. Morgan Stanley has predicted that by 2020 the P2P lending to businesses in Australia will increase to $11.4 billion.
P2P lending is attractive to small business lenders as these platforms will often require less paperwork from borrowers. P2P lenders will also place less onerous conditions on a loan than a bank will. The interest rates are typically between 10-15%, but can vary substantially because platforms have a competitive bidding process for a borrower’s loan. The term of the loan can range from 6 months to 5 years, with loan amounts available ranging between $2,000 and $2,000,000.
One potential downside for borrowers is that, at present, P2P lending is a lightly regulated section of the market, and as such there is potentially more scope for unethical behaviour. There is also frequently a loan application fee which must be paid, with no guarantee that the loan will be made. Some P2P lenders will also only offer financing for certain things, for example ThinCats Australia will only provide funding for business growth.
Advantages of P2P Lending: Gives access to alternate sources of funding, speedy application process, Limited security needed, and competitive loan tender process.
Disadvantages of P2P Lending: unregulated industry, relatively high rate of interest, ancillary charges.
Current Providers of P2P lending: Thin Cats Australia, Marketlend.
28. Why are pre-pack insolvency arrangements common-place restructuring transactions in the UK but not in Australia?
In the UK a pre-pack administration sale is a commonly utilised, and legal business rescue technique. It allows a business to be sold to the existing directors through a new entity.
Pre-pack arrangements are relatively common in the UK, where administrators arrange the sale of a business or company prior to the entity going into administration. In order to facilitate a successful pre-pack arrangement, the sale of a business, and or assets of an insolvent company, is agreed to prior to the appointment of an insolvency practitioner. The practitioner’s task once appointed is then to review the sale terms, and if legal and appropriate, to ratify the sale.
Under the UK pre-pack arrangement regime most businesses are sold as a going concern, with the company’s assets and undertaking sold together. Whilst in a prepack scenario, a company can continue to operate the business, often leaving employees and customers completely unaware of the situation until after commencement of voluntary administration.
One of the main obstacles in implementing a mirrored UK system here in Australia arises out of Australia’s stricter legislative regime. Under the Act once an administrator is appointed, a creditors meeting is held where, amongst other things, the fate of the company is decided. Using the approach utilised in the UK, the fate of the company is already decided prior to the appointment of the administrator, and without the input of creditors.
Australia has significantly stricter insolvency laws than that of the UK, proving another obstacle to the adoption of the UK pre-pack model. Additionally, insolvency practitioners in Australia are subject to strict codes of conduct. Essentially, insolvency practitioners are not permitted to have “substantial prior involvement” with a company to which they are later appointed. If a conflict arises in relation to the prior involvement of a practitioner in Australia the practitioner may be removed from the matter by court order. In the UK however, replacement of an insolvency practitioner is taken as a last resort as the conflict is often believed to be manageable. There is no policy backing for Australia to adopt a UK-style pre-pack regime.
29. What standards of valuations do courts expect for pre-pack insolvency arrangement?
There is no consistent line of reasoning that the courts have applied regarding the standard of valuation required in a pre-pack insolvency arrangement. This makes sense because the quality of the valuation report and the methodology that is appropriate would vary depending on the industry and size of the business. For example in many micro-businesses that have no maintainable earnings (in the absence of the proprietor) it would not be appropriate to value the business as a multiple of net earnings. That business may be valued by the break-up value of the assets.
The case study set out below found that except where there is a sham transaction, the standard applied by courts for the valuation of a business is a low bar. The Court found that as the transfer was not uncommercial it declined to set aside the transfer from Oldco to Newco.
In a pre-pack insolvency arrangement it is expected that Newco acquires the business assets of Oldco for value. It is essential for commercial value to be paid to avoid a liquidator making a claim for an uncommercial transaction against Newco or an unreasonable director-related transaction claim against the directors of Oldco.
The valuation methods broadly used are:
- Liquidation value;
- Fair market value; and
- Discounted cash flow value (multiple of maintainable earnings).
In any liquidation scenario potential purchasers will expect that assets are sold at “fire sale” prices. Liquidation value is the likely price of an asset when insufficient time is allowed to sell it on the open market, thereby reducing its exposure to potential buyers. Liquidation value is typically lower than fair market value.
Fair market value (FMV) is an estimate of the market value of a business, based on what a knowledgeable, willing, and unpressured buyer would probably pay to a knowledgeable, willing, and unpressured seller in the market.
Valuing a business as a multiple of maintainable earnings or discounting the cash flow is the most common method for valuing a business. It is also referred to as the discounted cash flow method. This method values a business by taking into account risk and discounting the expected cash flows to determine the value of the business. Each industry will have its own rule of thumb for the multiples of net earnings that is the expected market price for a business.
The multiple of maintainable earnings method is unlikely to be applied to a business which is completely dependent on the skill or relationships of the proprietor. For example, if a lawyer’s incorporated practice were to go into liquidation the liquidator would have the ownership of the practice files, WIP and debtors but not the solicitors themselves. In that case a valuation methodology based upon a multiple of maintainable earnings would be inappropriate as the lawyer could recommence practice through another firm and continue to act for the clients. In that case the value of the assets (being the files and WIP) would be calculated separately to the expected cash flows of a business.
Case study: What is an uncommercial pre-pack?
In the case of the Skouloudis Group a liquidator sought to set aside a transfer of a business shortly before a winding up petition against the company was determined.
Mr Skouloudis was the proprietor of the newspaper called O Kosmos through his company Skouloudis Group Pty Limited (i.e. Oldco). The company was in dire straits and the newspaper business was the principal asset of the business. It was acknowledged by Mr Skoudoulis that Oldco was insolvent before the business was transferred.
The liquidator of Oldco alleged that the transfer of the business was uncommercial and relied upon a list of indicia to prove their case. Both parties also agreed that the company was insolvent at the time of the transaction and that the purchaser was a related party.
A transaction is an uncommercial transaction if, and only if, it may be expected that a reasonable person in the company’s circumstances would not have entered into the transaction.
Why did the liquidator allege that the transaction was uncommercial?
The elements of the transaction that the liquidator sought to challenge were:
- There was no written contract and no ascertainable sale price but critically the liquidator didn’t allege it was a sham. The liquidator alleged that there was a transaction but that it was uncommercial.
- The director transferred all the assets and undertaking of the business from Oldco to Newco including the newspaper business, equipment, assignment of the lease, employees, intellectual property, advertiser lists, and everything necessary to run the newspaper.
- The purchase price was unspecified and it included taking over some liabilities of Oldco including staff entitlements, rent and printing costs. There is no reference in the judgment regarding whether OIdco’s tax debt was paid but it may be assumed it was not paid by Newco.
The focus of the Court was on the liquidator proving that the transaction was uncommercial. The Court found that because it was a related party transfer it should be looked at closely. The transaction involved Mr Skouloudis transferring the business to a company owned by his wife.
The Court was critical of the lack of evidence relied upon by the liquidator and found that the low purchase price, lack of documentation of the transaction and the related party purchaser did not necessarily make the transaction uncommercial.
The Court was not satisfied that the purchase was uncommercial and found that the transaction was “not necessarily an unreasonable transaction”. The Judge found:
If the newspaper business was the only asset of the company which it held beneficially, as appears to be the position, and if the company was unable to pay the debts of that newspaper business as appears to have been the case, then the disposal of that business for a sum sufficient to pay the liabilities, which the company was unable to pay was not necessarily an unreasonable transaction.
Because the liquidator didn’t prove the transaction was uncommercial they lost the case.
The lesson is that the courts are not usually interested in second-guessing commercial decisions unless there is a good reason to do so. When the provision allowing for the claw-back of uncommercial transactions was introduced into corporate law the explanatory memoranda summed up its purpose:
“The provision is specifically aimed at preventing companies disposing of assets or other resources through transactions which resulted in the recipient receiving a gift or obtaining a bargain of such magnitude that it cannot be explained by normal commercial practice.”
Therefore in Skouloudis Group, the liquidator could have likely succeeded by arguing that the transfer of the business was a sham and that there was no binding contract, the business was simply given away.
To avoid a liquidator’s claim the principal requirements for a transfer of a business from Oldco to Newco are:
- Valuation of the business; and
- A sale of business contract or asset sale agreement
One insolvency firm that specialises in pre-pack advice has recommended that the sale price of a business in a pre-pack should be somewhere between the auction value (i.e. a fire sale) and the going concern value, however, the case of Skoulooudis Group does not support the proposition that the sale price need necessarily be that high.
Crouch Amirbeaggi have developed a pre-pack process as follows:
- Pre-appointment review is undertaken of insolvent company by the insolvency practitioner;
- Conditional sale agreement is executed and licence agreement to allow business to continue to trade through Newco;
- Sale price agreed as the midpoint between the “auction” and “going concern value” of the business but it is not finalised until a valuation and public sale process by the liquidator;
- The liquidator is appointed and advertises the business for sale;
- If the liquidator receives an offer to buy the business from a member of the public the director of Newco will have the right to outbid it.
The obligations of the director of Newco are to attend to the following tasks after the appointment of the liquidator:
- Obtain a valuation of plant and equipment;
- Obtain a Work Health & Safety report of the trading premises;
- Provide details of the current insurance policy;
- Complete a stock take;
- Prepare accounting information for the sale of business information memorandum;
- Prepare business for sale advertisements; and
- Provide names and addresses of all staff and creditors.
The takeaway is that the benefit of a pre-insolvency advisor is assessing whether a pre-pack insolvency arrangement will save the business and its proprietors more value (and money) than self-help.
30. Are pre-pack insolvency arrangements possible if there are secured creditors?
A secured creditor is a creditor who has received security over some or all of the assets over a company in return for borrowed funds. This security will come in the form of either a mortgage over real property, or a security interest in specific personal property or a general security agreement over all the personal property (all present and after acquired property).
If a secured creditor is not paid the money owed to it, the principal enforcement remedy it has is to appoint a receiver. The task of the receiver is to take control of the secured property and sell it to repay the secured creditor’s debt. A receiver can only be appointed however if the instrument giving rise to the security grants the lender the power to appoint a receiver. The powers of the receiver will also be limited to what is granted either the Act and under the security agreement.
Where the security is held over real property (land) the consent of the secured creditor will be necessary before the asset can be transferred from Oldco to Newco. Personal property which is subject to a security can be transferred without the consent of the secured creditor, however the security generally survives the transfer and the secured creditor can take steps to enforce their security. As a result, to avoid action by the secured creditor, it will be necessary to transfer the liability to the secured creditor from Oldco to Newco, in order to avoid assets being seized and have the consent of the secured creditor.
Upon the appointment of a liquidator, a bank will generally engage with the liquidator but it is open for the bank to appoint a receiver over the top of the liquidator. The receiver takes control of the assets of the company subject to the bank’s security and the liquidator is left with an empty shell. However, if the bank is satisfied with the methodology of the pre-pack, and is satisfied that the business has been purchased for a fair price, they are less likely to appoint a receiver. The key is for the pre-pack advisor to communicate with the bank before implementing a pre-pack to avoid the reversal of the transaction after a liquidation commences or the transfer of the assets is executed.
It is clear that for any pre-pack of a company with secured creditors to be successful, the secured creditors will need to consent to the transfer of assets and approve the sale of the business. If this support is not obtained, it is likely that a receiver will be appointed and take measures to enforce the security and frustrate the sale.
31. What operational improvements can result from a pre-pack insolvency arrangement?
There are typically five root causes of SME insolvency;
- Poor management: The business has been poorly operated by its management.
- Big project: Entrepreneurs are typically optimistic about the success of their business. This can lead to big projects being taken on with inadequate market information or overly optimistic projections for timeframe, revenue, expenses and profits.
- Poor financial information: Often SMEs do not have the financial information necessary to accurately judge how the business is progressing. When this is allowed to continue for a period of time the SME may find itself in an unexpected cash flow crisis.
- Overtrading: Business growth costs money in the form of working capital and these requirements need to be properly estimated and provisioned for in advance.
- Add a predictable risk event: An otherwise predictable risk event could cause a business to fail because it is already vulnerable from one of the above 4 root causes.
A pre-pack insolvency arrangement is a structural change of the business but it can be part of significant operational change to ensure that the business is viable. A pre-pack is a structural change because the legal organisation of the business is changed and the nexus of contracts that keeps the business together are varied, terminated or novated. It does not directly change the operational nature of the business, and strategic thought may be required to address the cause of the business collapse, such as poor management, in the medium-to-long term.
There are a number of ways the business can be changed through the pre-pack process to facilitate operational change. One way is for Newco to only acquire those parts of Oldco which are profitable. This results in Newco being a newly efficient enterprise, with the less profitable or loss making parts of the business being left for the liquidator of Oldco to wind up.
Where a problematic big project has led to a cash flow crisis, the pre-pack can allow for the termination of the big project or transfer of the profitable elements into the new trading entity. The pre-pack arrangement also creates an opportunity for the business to start from scratch with improved business measurement and financial tools. Where a big project has involved optimistic assumptions, these assumptions can be revised. The new company can take a fresh approach to managing its financial information to achieve more accurate knowledge of the business’s financial position. More accurate reporting will allow the business to improve its business metrics, such as return on investment and asset utilisation. A more thorough understanding of the business’s financial performance will also allow management to eliminate unnecessary expenses and focus on profitable services or products.
This operational turnaround can result in global change for the business with a completely new strategy and vision for the new trading entity. Alternatively change could be restricted to a micro level with the addressing of issues such as the termination of underperforming staff.
Most importantly a pre-pack can create the breathing space necessary for managers to review their performance and the performance of the business. Rather than spending their time responding to demands from creditors, managers would be able to review their processes and improve those parts of the business which contributed to the business’s cash flow crisis. It is important at a pre-pack stage for the end game of the business to be defined.
32. Are pre-pack insolvency arrangements possible if premises and/or plant and equipment are all leased?
There are two separate categories of leases which will need to be addressed in a pre-pack insolvency arrangement, premises and equipment. The takeaway is that the consent of the landlord and equipment financiers will likely be required in a pre-pack insolvency arrangement.
Lease of Premises
An important part of negotiating a pre-pack insolvency arrangement may be a negotiation with a landlord to allow the business to continue operating from its premises. An assignment of the lease from Oldco to Newco has some commercial advantage for the landlord as it allows for continuity and stops the landlord from losing a tenant.
Fixtures to the property are generally considered to be the landlord’s property and can be transferred with the lease. Fixtures include anything that is attached to the property (being held down by more than its weight), unless there is a right of removal in the lease. Anything not attached is a chattel and is personal property. Separate arrangements need to be made for the transfer of chattels from Oldco to Newco.
When negotiating for the assignment of the lease it will be necessary to re-negotiate any bank guarantees that may have been given by Oldco to the tenant. It is not preferable to have the landlord return the bank guarantee to Oldco before the appointment of a liquidator. If the bank guarantee is returned after the appointment of the liquidator the funds may be held by the liquidator.
It is preferable that the lease be assigned before the appointment of the liquidator, as this will allow for the transfer of the bank guarantee (and its replacement). It is also possible to sign a new lease with the landlord after a liquidator has been appointed to Oldco because they can then disclaim Oldco’s lease.
If there is a valuable fitout of the premises, as could be the case with a business such as a restaurant or a retail store, it may be necessary to delay the sale of the business until after the appointment of the liquidator. It may be necessary to convince the liquidator that the valuation of the business has made adequate provision for the value of the fitout. If the sale of the business is made before the appointment of the liquidator and the liquidator is not satisfied that the value of the fitout has been included, the liquidator may attempt to challenge the transaction. In this instance the director may be protected by a properly prepared valuation in support of any business transfer and related assignment of a lease.
Lease of Equipment
Any equipment, which is not a fixture, and is leased from a financier, will need to be transferred from Oldco to Newco to fully effect the pre-pack. Negotiation with financiers to facilitate this is a key part of negotiating a pre-pack arrangement.
One of the main challenges with this process will be getting the attention of the financiers. Many financers, in particular larger financiers, may not be interested in assisting with a pre-pack arrangement, as they do not want to spend the time on what they would consider to be a relatively small matter.
If the pre-pack insolvency arrangement is to be finalised after the appointment of the liquidator it will be useful if the leased equipment has a balloon payment. A balloon payment is a large payment that is payable at the end of the lease in return for the leased goods. It has the effect of reducing the payments that need to be made during the life of the lease. It also has the effect of reducing the equity available in the leased goods for the liquidator. As they will be unable to gain any benefit for creditors by maintaining the lease themselves the liquidator is likely to agree to the novation of the lease in circumstances where there is a balloon payment. If there is not a balloon payment, the residual value of the leased assets may need to be taken into account when valuing the business to avoid claw back action by the liquidator.
33. What do the courts regard as a sham or fraudulent transaction?
Sham and fraudulent transactions have been a common focus of the law for centuries. Diplock LJ determined in Snook v London and West Riding Investments Ltd  2 QB 786 that sham can be defined as:
“..acts done or documents executed by the parties to the ‘sham’ which are intended by them to give to third parties or to the court the appearance of creating between the parties legal rights and obligations different from the actual legal rights and obligations (if any) which the parties intend to create.”
Although there is no provision in corporate law or elsewhere that expressly uses the term phoenix activity, the fraudulent form of the behaviour will always be a breach by the director of their duty to act in good faith in the best interests of their company, and for a proper purpose, and not to improperly use their position to make a gain for themselves or someone else, or to cause detriment to the corporation.
Offences of fraud are committed where a person obtains property from another by a dishonest act of deception. Section 192E of the Crimes Act 1900 (NSW) determines that a Fraud is a person who, by any deception, dishonestly obtains property belonging to another, or obtains any financial advantage or causes any financial disadvantage. In order to commit an act of fraud, the deception must be intentional or reckless in nature.
Hill J in Faucilles Pty Ltd v FC of T  FCA 791 considered that a sham transaction is one which is intentionally created to have no legal effect, if there is a common intention of the parties that the transaction should be a cloak or disguise for another transaction, or no transaction at all.
A transaction is a sham where the parties to the transaction act with a common intention not to create legal rights and obligations, although the transaction on face value, gives the appearance of creating those legal rights and obligations.
Sham transactions are legally ineffective; however it is important to note that not all ineffective transactions will be considered shams even if illegality is an element.
There are many examples of sham or fraudulent transactions that have been entered into by insolvent companies. Such as in R v Heilbronn where the director of a company with substantial sales tax liabilities, stripped the company of its assets and transferred them to another company, and then to a third company. On each occasion, the same business was carried under the same trading name. A proper price had not been paid for the assets, and no effort was made to ensure the liabilities and other legal obligations had been met.
For a court to establish that a sham or fraudulent transaction has taken place, it must decide whether the parties to the transaction intended to mislead third parties by the execution of the documents that were purported to create the legal rights and obligations relied on by third parties.
Simply put, just because an agreement produces a result that the creditors do not like, or may seem as though the agreement was entered into for the purpose of improving one person’s position unfairly against another person, it does not entitle the court to conclude that a sham transaction has occurred. A sham is pretence and it involves the court finding that the real agreement entered into by the parties is something other than what is appears to be on the face of the documents.
It is vital that all documents prepared for a pre-pack arrangement should be properly drafted legal documents with an arguable commercial benefit. Failure to prepare documents may cause a pre-pack to be set aside by a liquidator.
 ASC Research Paper 98/01, A study of voluntary administrations in NSW, Australian Securities Commission, Sydney, 1998 at pp26-27
 Eow, I., ‘The door to reorganisation: Strategic behaviour or abuse of voluntary administration?’ Melbourne University Law Review 11 (2003) 30 2
 Parliamentary Joint Committee on Corporations and Financial Services, Corporate Insolvency Laws: a stocktake June 2004, Chapter 5 at [5.12]
 Corporations Act 2001 (Cth) Section 450A.
 ARITA Code of Professional Practice Rule 6.8.1(B).
 Phoenix activity is not defined by the Corporations Act 2001.
 Australian Government, Action Against Fraudulent Phoenix Activity November 2009, Phoenix Proposal Paper, www.archive.treasury.gov.au/documents/1647/PDF/Phoenix_Proposal_Paper.pdf.
 Crimes (Taxation Offences) Act 1980 s5.
 Crimes (Taxation Offences) Act 1980 s6.
 Crimes (Taxation Offences) Act 1980.
 Helen Anderson, “The Proposed Deterrence of Phoenix Activity: An Opportunity Lost”, (2012) 34(3) Sydney Law Review 411 p417.
 Australian Securities Commission 1996, Research Paper No 95/01-Phoenix Companies and Insolvent Trading, Canberra.
 Discussed at Chapter 24.
 Helen Anderson, “The Proposed Deterrence of Phoenix Activity: An Opportunity Lost”, (2012) 34(3) Sydney Law Review 411 p424.
 Helen Anderson, Ann O’Connell, Ian Ramsay, Michelle Welsh, Hannah Withers “Defining and Profiling Phoenix Activity”, December 2014.
 Helen Anderson, Ann O’Connell, Ian Ramsay, Michelle Welsh, Hannah Withers “Defining and Profiling Phoenix Activity”, December 2014 p1.
 Corporations Act 2001 s588FF.
 Corporations Act 2001 s588FB.
 Corporations Act 2001 s588FDA.
 Corporations Act 2001 s 588FE.
 Australian Government ‘Welcome to the Ideas Boom’ Fact Sheet 8 Insolvency Reform.
 Section 10 Fair Entitlements Guarantee Act 2012 (Cth).
 “Pre-Packs: A Legitimate means to Phoenix an Insolvent Company” Crouch, N & Amirbeaggi, S. (2011) 23(1) A Insol J 30-35.
 Corporations Act (2001) (Cth) s 181.
 Ibid s182.
 Bayly v FC of T (1997) 15 SASR 446.
 Lau v FC of T (1984) 54 ALR 167).
 R v Heilbronn (1999) 30 ACSR 488.