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Second Chance for an insolvent SME: Alternative Pre-pack insolvency arrangements – part 1

Second Change for an insolvent SME: Alternative Pre-pack insolvency arrangements whitepaper – part 1.

Table of contents (Part 1)

Overview
1. What is a pre-pack insolvency arrangement?
2. Who should read this whitepaper?
3. What is a pre-pack voluntary administration?
4. Who is suitable for a pre-pack insolvency arrangement?

Insolvency issues for SMEs
5. What are SMEs and why are they important?
6. What financial and operational issues do SMEs face?
7. What is the legal meaning of insolvency?
8. What are the indicators of insolvency recognized by Courts?

 

OVERVIEW

1. What is a pre-pack insolvency arrangement?

The market for insolvency services is rationalising and particularly with small-to-medium sized enterprises, lower cost and less disruptive methods for rescuing insolvent businesses are becoming the focus of the profession. The pre-pack insolvency arrangement is an opportunity to achieve a business rescue without the cost and disruption of a voluntary administration.

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 scheme” and now “phoenix activity” contrast with legal pre-pack insolvency arrangements.

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 poor and illegal advice that leads to phoenix activity.

The essential preconditions for a pre-pack insolvency arrangement are that a business is insolvent, and that the business has an intention to restructure their affairs to rescue it and give directors a second chance. Pre-packs 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). 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 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

  1. The transaction takes place before Oldco is placed in insolvent administration.

The pre-pack insolvency arrangement is not widely used in Australia but it has been recognised as a valid methodology by courts, the insolvency profession and government bodies. The pre-pack insolvency arrangement was acknowledged as a legitimate restructuring transaction in a recent government report into phoenix activity:

“A genuine business failure where the business has been responsibly managed and subsequently continues using another corporate entity is a legitimate use of the corporate form”[1].

2. Who should read this White Paper?

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 poor advice has expensive consequences of personal liability for tax debts and determination of market standing for rebirthed businesses.

SMEs are businesses employing less than 200 people, these businesses represent 99.7% of businesses in Australia. SMEs have unique needs because they have small shareholdings (i.e. usually an entrepreneur or a family), they are sensitive to professional fees and often have poor business processes and records. SME professional advisors need to have a whole business approach in identifying obstacles including personal, operational and financial difficulties that their clients face. This information should then be utilised when developing a rescue strategy.

This whitepaper is relevant for a range of people involved with SMEs, including:

  • SME directors;
  • Accountants;
  • Insolvency practitioners;
  • Property and transactional lawyers;
  • Family and estate planning lawyers; and
  • Insolvency lawyers.

This is not a “tips and traps guide” or “7 things you must do to implement a pre-pack rescue”. There is no single accepted methodology for planning and implementing a pre-pack insolvency arrangement because of the complexities of tax law, corporate law and market realities faced by SMEs.

3. What is a pre-pack voluntary administration?

A pre-pack voluntary administration occurs when there is an arrangement (i.e. a restructuring plan) planned before the appointment of a voluntary administrator. The arrangement is likely to include the transfer of business assets from Oldco to Newco, but the transaction may be completed either before or after the appointment of the voluntary administrator.

The primary difference between a pre-pack voluntary administration and a ‘regular’ voluntary administration is that in a pre-pack arrangement, the planning and negotiation of the business transfer takes place prior to the appointment of the voluntary administrator. Valuations would have already been obtained, contracts drafted and the sale price agreed before the appointment of a voluntary administrator in a pre-pack scenario.

In a ‘regular’ voluntary administration, the voluntary administrator takes over the management of the insolvent business and only begins sale or payment negotiations with stakeholders after their appointment. After assessing the viability of the business the administrator decides whether to continue trading under the business during the administration period, or close it down. There is a second meeting of creditors that decides the future of the business and whether creditors will accept a compromise or put the company into liquidation.

The deed of company arrangement (DOCA) is the primary binding instrument between the creditors, directors and the voluntary administrator when any compromise maybe made with the directors. A DOCA proposal is subject to a vote of creditors, and therefore needs creditor support.

The obvious benefit of a pre-pack insolvency arrangement is that the directors of the insolvent business retain control of the business throughout the insolvency process. This is the case of the pre-pack transaction executed before the appointment of a voluntary administrator or liquidator. On the other hand, if the pre-pack transaction is not executed before the appointment of a voluntary administrator it is unlikely that the voluntary administrator will finalise the transaction without the approval of creditors.

In a “regular” voluntary administration the voluntary administrator will evaluate any purchase offer of the business and will be unlikely to approve a sale before it is considered by the second meeting of creditors.

4.  Who is suitable for a pre-pack insolvency arrangement?

The two key characteristics of an insolvent SME that may be suitable 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
  • 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. Accountants would say that goodwill amounts to the excess of the “purchase consideration” (i.e. the money 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.

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 eradicating the goodwill 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, 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 to the suppliers and customers. An ipso facto clause gives a customer or supplier of a company in administration or liquidation the right to terminate a contract based upon insolvency. In Australia an ipso facto clause of a contract is not illegal, unlike in the United States. This means that upon a formal insolvency appointment the customers and suppliers of Oldco have the right to stampede and the effect would reduce the goodwill value of Oldco.

There is currently very little empirical research into the costs of voluntary administration but it may be observed however, that the costs of a voluntary administration are on the increase. It may be expected that a voluntary administration for an SME will cost between $50,000 and $200,000. It is often uncommercial to appoint a voluntary administrator to a company, particularly in the case of microbusinesses with 1-4 employees and SMEs, as the costs could consume all the value in the business solely in administrator’s fees.

Pre-packs are quicker sales where the insolvent company (i.e. Oldco) can usually continue trading through Newco without going through a voluntary administration process. This would enable the company to retain the value of their brand, their employees and key customers.

 

INSOLVENCY ISSUES FOR SMES

5. What are SMEs and why are they important?

A small-to-medium size enterprise (SME) is any business that employs up to 200 employees. The Australian Bureau of Statistics (ABS) reported in its count of Australian businesses that as at June 2014 there were 826,393 employing businesses and of these:

  • 571,176 had 1-4 employees (microbusinesses);
  • 197,412 employed 5-19 employees (small businesses); and
  • 51,688 employed 20-199 employees (medium businesses) [2].

The relative size of SMEs, compared to large corporations and government entities, belies the importance of the segment to the economy. SMEs contribute one half of private sector employment and one third of private industry value-add [3].

The ABS also reported that microbusinesses had a 9.7% exit rate and a 14.6% entry rate, indicating a very active economic space [4]. Although “exit” does not necessarily mean all those businesses had become insolvent we can assume that a significant proportion were insolvent or at least unviable.

97.4 percent of micro businesses are wholly Australian owned [5], meaning they are more reliant upon a smaller number of customers and members of their local community. In such a case, the community is likely to feel the effects more heavily in the disruption of SME’s, with a high chance the disruption impacts on them directly, being owners and employees of such entities.

The small-to-medium sized businesses are the backbone of the economy, it is important for professional advisors as key clients to understand their importance.

6. What financial and operational issues do SMEs face?

SMEs have historically suffered from higher costs of capital and after the Global Financial Crisis (GFC) the problem was exacerbated. Before the GFC (2001 to 2008) SMEs paid a premium of at least 1.5% above the interest rates paid by large businesses, since this time the spread has jumped to at least 2% [6]. SMEs are reported to most commonly seek finance to maintain short term cash flow or liquidity [7].

Access to finance is a critical issue faced by SMEs and anecdotal evidence suggest the banks are avoiding lending to SMEs overall.

The root causes of insolvency issues that are faced by SMEs today are:

  • Australia’s slow paying culture; and
  • Poor management.

The objective of the next section is to explore the root causes of SME insolvency. A discussion paper released by the Federal Government regarding the Prompt Payment Protocol asserted that 90% of small business failure is caused by poor cash flow.[8] It showed that Australia has a national culture of paying suppliers slowly in the business-to-business (B2B) context. The research compares Australia and New Zealand’s B2B debt payments and found that there is a marked difference between the times for these debts to be paid, on average:

Australia 54.1 days v NZ 43.1 days.[9]

This is not so much a legal issue but a micro-economic reform issue because SMEs are particularly vulnerable to cash flow crunches. The best example is the Building and Construction Industry which has historically had the highest rate of insolvencies. To remedy this, construction contracts with “pay when paid” terms for payment have been outlawed and subcontractor payments sped up through the Security of Payment legislation.[10]

Often the question is asked, what is the point of no return in the spiral to insolvency? The answer is chronic insolvency, winding up applications, Director Penalty Notices from the ATO, staff walking out the door, being put on stop by suppliers and deadlock between owners and/or management. These are all features of the spiral towards insolvency, however, these are symptoms rather than root causes of insolvency.

If we think like doctors about causes and symptoms, the research supports the proposition that poor management, the big project and overtrading are the most common root causes of insolvency.

Cause 1: Poor management

The bad news is that the prime cause of business failure is poor management.

Here is what to look out for as indicators of poor management:

  • Refusal to seek or take advice: A director should look to advisors who have been through insolvency situations and understand the strategic issues that the business faces;
  • Narrow-mindedness: Directors who only show interest in matters that concern their particular area of expertise or interest. Also directors that lack finance experience and/or do not have suitable financial advisory services at hand; and
  • People skills: There is no need to have a business study accreditation or a great deal of emotional intelligence to establish hard-worked performance expectations. Down-to-earth, direct and goal-oriented managers are likely to get the most from their staff.

Cause 2: The Big Project

Entrepreneurs are likely to be optimistic. They may take on a big project without up-to-date financial information or reasonable forecasts. In this situation costs and timeframes are often underestimated and/or revenue is overestimated, more likely than not, leading to a cash flow crunch.

Cause 3: Overtrading

It is obvious to point out that business growth costs money (i.e. working capital) because additional funds are required to build the business before actual income from increasing revenue is received.

Overtrading is another major cause of business failure. Challenging targets are set for the business and employees but the cash flow effects of expanding the business is not properly estimated before execution.

Add predictable business risk event

If a business is already in a tight financial situation because it is overtrading, taking on too big projects, or is poorly managed, an otherwise predictable event may cause the business to fail. These risks are not likely to cause a healthy business to fail but may cause a vulnerable business to tip over. Unfortunately there is no way to prevent these normal business risks. Losing a big customer, having a key person in the business suffer ill health, economic downturn or an act of god (weather, war, etc.), are examples of these unpredictable events. The old rule of thumb is that a business needs 3 months of business expenses saved in order to be covered in the event of a predictable business risk event.

Add creative accounting

When a business is failing it can be tempting to get ‘creative’ with accounting. This is one symptom of impending business failure. Creative accounting can often be an unintended result of trying to reframe the problem.

Beware if any of the following symptoms occur:

  • Delay in producing financial statements;
  • Continued payment of dividends (i.e. drawings) by relying on debt rather than retained earnings;
  • Cutting expenditure on routine maintenance;
  • Starting to treat extraordinary income as ordinary income and vice versa;
  • Changing ownership title of main assets in the business;
  • Valuing assets at inflated figures;
  • Meeting company debts out of the Director’s own pockets; and
  • Valuing stock of dated products at the current market selling price rather than at cost.

Watch out for tax debts

The Director Penalty Notice (DPN) regime is a big challenge that is adversely affecting entrepreneurs and directors of SMEs. The ATO is training their staff and automating their processes to issue DPNs regularly. The ATO are “punching” a lot of these out through data matching and document automation systems. A DPN allows the ATO to pierce the corporate veil meaning that directors may be personally liable for tax debts resulting from unpaid Superannuation Guarantee Charge (SGC) and unpaid PAYG contributions.

Since 2012 directors of SMEs are held to be personally liable for PAYG and SGC contribution liabilities that are both unpaid and unreported for three months. The personal liability accrues irrespective of whether the ATO issues a DPN, the DPN now however crystallises the date that the personal liability is due to be paid. Personal liability cannot be avoided if the unpaid liability was unreported for three months. Directors will also be unable to avoid personal liability under the director penalty notice by placing the company into voluntary administration or having it wound up.

7. What is the legal meaning of insolvency?

Section 95A of the Corporations Act 2001 (Cth) (the Act) defines “insolvency”. Under the Act a company is insolvent if it is unable to pay its debts as and when they become due and payable. It is known as a “cash-flow test” of insolvency, because a company may have more assets than liabilities on their balance sheet but are considered to be insolvent because they cannot sell their assets fast enough to satisfy their debts as they become due and payable. What is required is that a company have a chronic shortage of working capital, rather than be suffering from a temporary lack of available cash.

The “cash-flow test” is preferred over other tests of solvency, as it is a more accurate test of the viability of a company’s business. Even if a company has an excess of assets they may not be able to sell them in time to satisfy the debts of the company. On the other hand, a company with substantial debts may be able to trade its way out of difficulties if the debts are long term and the company is profitable.

The “cash-flow test” requires an analysis of:

  • The company’s existing debts;
  • Whether the company’s debts are payable in the near future;
  • The date each debt will be due for payment;
  • The company’s present and expected cash resources; and
  • The dates any company income will be received.

The Court will consider whether the company is suffering from a temporary lack of liquidity (and therefore is not insolvent) or whether the company faces an “endemic shortage of working capital”. In order to find that a company is insolvent a court will need to be convinced that the company has gone past the “point of no return” and is no longer viable to trade.

A court is also able to find that a company is presumed to be insolvent due to its failure to keep books and records as required by section 286 of the Act. In order for this presumption to be made, a liquidator needs to prove that either no records at all were kept or that the records that were kept are factually inaccurate and do not allow an accurate picture of the company’s affairs to be made.[11] As any honest records the company holds will be enough to rebut the presumption of insolvency, Section 286 of the Act is rarely relied upon to prove insolvency.

8. What are the indicators of insolvency recognised by Courts?

When assessing whether a company or individual is insolvent and when that insolvency started, the courts refer to a number of factors.

In ASIC v Plymin & Ors (2003) 46 ASCR 126 (commonly referred to as the “Water Wheel case”), Justice Mandy of the Supreme Court of Victoria referred to a checklist of 14 indicators of insolvency:

  • Continuing losses;
  • Liquidity ratio below 1 (a ratio of current assets to liabilities);
  • Overdue Commonwealth and State taxes;
  • Poor relationship with present bank including inability to borrow additional funds;
  • No access to alternative finance;
  • Inability to raise further equity capital;
  • Supplier placing the debtor on COD (Cash on Delivery) terms, otherwise demanding special payments before resuming supply;
  • Creditors unpaid outside trading terms;
  • Issuing of post-dated cheques;
  • Dishonoured cheques;
  • Special arrangements with selected creditors;
  • Solicitors’ letter, summons(es), judgments or warrants issued against the company;
  • Payments to creditors of rounded figures, which are irreconcilable to specific invoices;
  • Inability to produce timely and accurate financial information to display the company’s trading performance and financial position, and make reliable forecasts.

This is not an exhaustive list and it is not necessary for all of the above factors to be present for a company to be considered insolvent. It is possible for a company to remain solvent even when many of the above factors are present. This is particularly true where sufficient outside funds are available, such as funds from a director or other related party. It is possible for a company to prove solvency where they can show that an outside party could come to the company’s aid. In this regard, it is important to note that the test for insolvency requires that a company is unable to pay debts. This inability to pay is not proven by the mere fact that debts were not paid. If the company could choose to ask for outside help, but did not, they may still be considered solvent.

 

FOOTNOTES:

[1] Action against fraudulent phoenix activity, November 2009, Treasury Australian Government, page 1

[2] Australian Bureau of Statistics, 2014, 8165.0 Counts of Australia Businesses, Including Entries and Exits, June 2010 to June 2014 at page 21.

[3] Australian Treasury, Australian Small Business, December 2012, report published online at www.treasury.gov.au

[4] Australian Bureau of Statistics, 2014, 8165.0 Counts of Australia Businesses, Including Entries and Exits, June 2010 to June 2014 at page 21.

[5] Australian Treasury, Australian Small Business, December 2012, report published online at www.treasury.gov.au at page 31.

[6] Australian Treasury, Australian Small Business, December 2012, report published online at www.treasury.gov.au at page 61.

[7] Australian Treasury, Australian Small Business, December 2012, report published online at www.treasury.gov.au at page 34.

[8] Australian Government, Department of Industry, Innovation, Climate Change, Science, Research and Tertiary Education, Australian Prompt Payment Protocol, Discussion Paper, July 2013 at page 4.

[9] Australian Government, Department of Industry, Innovation, Climate Change, Science, Research and Tertiary Education, Australian Prompt Payment Protocol, Discussion Paper, July 2013 at page 10.

[10] For example, Building and Construction Industry Security of Payment Act 1999 (NSW).

[11] Fisher v Devine Homes Pty Ltd; Allen v Harb [2011] NSWSC 8.

 

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