By Ben Sewell, Sewell & Kettle Lawyers
Sewell & Kettle Lawyers have published the only whitepaper in Australia on pre-pack insolvency arrangements and how they can be utilised by insolvent small-to-medium sized enterprises.
A summary of the key elements of the white paper is below. The complete whitepaper can be downloaded here: Click here to download the white paper.
What is a pre-pack insolvency arrangement?
A pre-pack insolvency arrangement is an instrument for rescuing an insolvent business through a legally binding transaction either before or after the formal appointment of an insolvency practitioner. It is an alternative to using voluntary administration for rescuing an insolvent business from a liquidation fire sale.
The methodology of using a private treaty to rescue an insolvent business without principally resorting to a formal insolvency appointment is not new. Illegal private treaty arrangements, originally “bottom of the harbour” schemes and now “phoenix activity” contrast with legal pre-pack insolvency arrangements. The purpose of this White Paper is to help professional advisers to understand alternative approaches to informal work-outs without resorting to phoenix activity.
The terms “pre-pack”, “pre-pack insolvency” and “pre-pack arrangement” are interchangeable but “pre-pack insolvency arrangement” will be used in this discussion paper. This discussion is focused on legal pre-pack arrangements and helping directors and entrepreneurs to avoid litigation and fall out from both poor quality and illegal advice that can lead to phoenix activity.
The essential preconditions for a pre-pack insolvency arrangement are that a business is insolvent and that the directors have an intention to restructure their affairs to rescue the business. Pre-packs may also apply to sole traders and partnerships but these vehicles for trading have been largely overtaken by the corporate form (i.e. a proprietary limited company) so sole traders and partnerships are not discussed in this paper. Sole traders and partnerships are only prevalent now in industries where professionals are prohibited from trading through corporate entities.
A pre-pack insolvency arrangement has the following elements:
- A company (Oldco) is insolvent;
- Oldco’s business is transferred for commercial consideration to a related entity (Newco); and
- The transaction between Oldco and Newco results in an optimal outcome for stakeholders.
There are two types of pre-pack insolvency arrangements:
- The transaction takes place after Oldco is placed in insolvent administration (i.e. liquidation or voluntary administration); or
- The transaction takes place before Oldco is placed in insolvent administration.
The insolvency profession is generally against promoting or utilizing pre-pack insolvency arrangements. The focus of the Australian insolvency regime has been to have an independent insolvency practitioner appointed over insolvent companies through a formal restructure process (i.e. a voluntary administration). It is understandable that insolvency practitioners would resist informal arrangements, because it results in less profitable work and a loss of control over the insolvency process. However, professional advisers should be aware that if a company is insolvent, at some point in time it may ultimately be placed in liquidation and at that time the insolvency practitioner appointed will have the task of reviewing the pre-pack insolvency arrangement. Therefore, it is essential for any director undertaking an informal work-out and asset transfer to strictly comply with their legal obligations or they may face a claw-back action by a liquidator down the track.
Who should read this whitepaper?
The purpose of this White Paper is to inform small-to-medium sized enterprise (SME) directors and their professional advisors about pre-pack insolvency arrangements and the consequences of poor restructuring advice.
The White Paper is also a challenge to phoenix activity promoters whose illegal advice has expensive consequences of personal liability for tax debts and the continuation of unsustainable business. It is not in anyone’s interest to continue a loss-making business and directors are better off doing something else!
What questions does the whitepaper answer?
The sections of the whitepaper are listed below:
1. What is a pre-pack insolvency arrangement?
2. Who should read this White Paper?
3. What is a pre-pack voluntary administration?
4. Who is a pre-pack insolvency arrangement suitable for?
5. What is the safe harbour from insolvent trading?
6. What is phoenix activity?
7. Why is the ASIC, the ATO and Department of Employment becoming more active in pursuing phoenix activity?
8. What is the difference between a secured and an unsecured creditor?
Insolvency issues for SMEs
9. What are SMEs and why are they important?
10. What financial and operational issues do SMEs face?
11. What is the legal meaning of insolvency?
12. What are the indicators of insolvency recognized by Courts?
Directors and advisors of SMEs
13. What are the principal legal duties of directors?
14. What is insolvent trading?
15. How does a director get a safe harbour protection from insolvent trading?
16. Why do directors need to watch out for Director Penalty Notices (DPNs) from the ATO?
17. What penalties can directors face for insolvent trading and breach of duty?
18. What immediate actions should directors of an SME take if their company is insolvent?
19. What types of professional advisors assist with a pre-pack insolvency arrangement?
20. What are the duties of professional advisors advising insolvent SMEs?
Liquidators of SMEs
21. Who are liquidators and what do they do?
22. What is the downside of a liquidation firesale?
23. When can a liquidator claw back transactions made to related entities, including a new company?
24. What factors do liquidators take into account when they decide whether to pursue illegal phoenix activity?
Voluntary administrators of SMEs
25. What is voluntary administration?
26. Why do SMEs appoint voluntary administrators?
27. What are the downsides of voluntary administration?
28. Why is voluntary administration impractical for a microbusiness (1-4 employees)?
29. Are insolvency practitioners under a conflict of interest when advising on a pre-pack voluntary administration?
30. What are the future prospects of voluntary administration: are results improving or declining?
Restructuring of SMEs
31. What is informal restructuring?
32. How does a director obtain safe harbour protection from insolvent trading?
33. What does the law consider to be phoenix activity?
34. When can an insolvent business be transferred to a related entity?
35. How does Fair Entitlement Guarantee treat employees when a business is liquidated?
36. If employees are transferred from a company in liquidation, do employee entitlements transfer?
37. How can directors be penalised for phoenix activity and utilising FEG to pay outstanding entitlements?
38. What does the licensing of business mean?
39. What types of finance are available for a pre-pack insolvency arrangement?
40. Why are pre-pack insolvency arrangements common-place restructuring transactions in the UK but not in Australia?
41. What standards of valuations do courts expect for a pre-pack insolvency arrangement?
42. Are pre-pack insolvency arrangements possible if there are secured creditors?
43. What operational improvements can result from a pre-pack insolvency arrangement?
44. Are pre-pack arrangements possible if premises and/or plant and equipment are all leased?
45. What do the courts regard as a sham or fraudulent transaction?
46. Capstone comment: Why is it difficult to successfully execute a pre-pack insolvency arrangement?
Who is a pre-pack insolvency arrangement suitable for?
Two key characteristics of an insolvent SME that qualify it for a pre-pack insolvency arrangement are:
- That there is a serious commercial issue with the goodwill in a business being damaged by a formal appointment scenario; and/or
- The costs of a voluntary administration are uncommercial.
The goodwill of a business is the value of a business over and above the price of all the assets of the business when broken up. Accountants would say that goodwill amounts to the excess of the “purchase consideration” (i.e. the price someone is willing to pay to purchase the assets of the business) over the total value of the assets. If a formal appointment (i.e. a liquidation or voluntary administration) is likely to damage goodwill or otherwise significantly reduce a potential purchase price of the business this is a valid commercial justification for a pre-appointment transfer of the business of Oldco to Newco.
In a liquidation scenario, the liquidator is under no obligation to continue trading a business and if they do, they are at personal risk if a liquidation trade-on suffers a loss. As a result of liquidation, the business may be terminated or put on hold, significantly impacting if not eliminating the goodwill value of the business. The liquidation of a company is likely to result in a total loss in the goodwill of a company. To avoid such a scenario, however, a liquidator does have the right to licence the business as a means of ensuring its continuity.
It is likely that the damage to goodwill value will have already been done by notification of the liquidation or voluntary administration to the suppliers and customers.
What is the downside of a liquidation fire sale?
If company goes into liquidation, the liquidator is under an obligation to sell the assets of the company. Their legal obligation in the sale process isn’t significant because they are only under an obligation to sell the assets for the best price reasonably obtainable at the time of sale. That means any sale process is likely to be hurried: essentially, a 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 earnings 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 (Section 477(1)(a) Corporations Act). Liquidators would also be likely to seek the approval of a committee of creditors before taking a risk and trading on 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 useful to point out that a liquidator has no “skin in the game” in the sale process.
A liquidator is remunerated 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. Most of a liquidator’s fees will be generated by having junior staff conduct due diligence, deal with various stakeholders and otherwise “tick boxes”. Ultimately, the longer the liquidator delays the sale process, the longer it will take to realise the bulk of their professional fees.
This may be described as an agency problem. The Australian insolvency system (unlike the United States and Chapter 11 of their Bankruptcy Code) 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:
- Private contract;
- Public auction;
- Tender; or
- 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 “bidder’s 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.
What is informal restructuring?
An informal restructuring is a confidential process for turning around financial results, renegotiating contracts and changing the legal structure of a business. It could also be called a “workout” and it could involve refinancing, changes to operations, crisis management and termination of contracts (including employees). An informal restructure could utilise the safe harbour from insolvent trading in the event that the company was insolvent. There is no universally accepted definition of what an informal restructuring is and it is not defined in the Corporations Act 2001.
Keay’s Insolvency (Tenth Edition) provides the following definition (page 883):
“Workout refers to an informal agreement between a debtor and one or more of its major creditors which alters the terms of their contractual payment arrangements to allow the debtor to improve its financial position…
A restructuring may involve the implementation of a workout proposal, in which case it is usually referred to as a balance sheet restructuring…”
An informal restructuring is the opposite of a formal restructure. A formal restructure utilises the provisions of the Corporations Act 2001 to restructure through the appointments of voluntary administrators, liquidators and receivers. Alternatively, for large enterprises a scheme of arrangement may be utilised. A restructuring may be informal not in the sense that it is unenforceable at law or through contracts but rather that the mechanism used is not referred to or set out in the Corporations Act 2001.
An informal restructuring process for an insolvent company may commence with the initiation of a safe harbour protection from insolvent trading under section 588GA of the Corporations Act 2001. The directors would need to “start to develop a course of action” to turn around the business. If the business is not insolvent this is not required.
The key benefit of an informal restructure is that the process is confidential and this may be essential in an industry that is sensitive to insolvency (such as building and construction). If the business’s customers, employees and creditors were aware of insolvency their sensitive reactions may result in the collapse of the business.