Discussion Paper: Options to address fraudulent phoenix activity. by Cameron McDonald

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1 Discussion Paper: Options to address fraudulent phoenix activity by Cameron McDonald

2 1 CONTENTS Background.. 1 Purpose of Paper....1 Methodology....1 Structure of Paper..1 The Phoenix Company Incentives of phoenix activity under the current Corporations Act.3 Methods of Combating Phoenix Activity outside of the Corporations Act.6 Areas where law does not make sense 8 Current law in need of reform.9 Main Conclusion...11 Bibliography..12

3 1 Background There has been an increasing level of awareness in respect of the phoenix company over the past three years with Government departments and regulatory bodies stepping up their initiatives to perpetrate offenders of this fraudulent practice. Thousands of incidences but only a handful of convictions every year have prompted stronger enforcement and tighter legislation changes however there are still significant loopholes available for exploitation by phoenix directors. Purpose of Paper The purpose of this paper is to outline any inherent provisions of the current Corporations Act that encourage the use the phoenix companies within the Australian economy and suggest possible reforms in certain areas of the law to resolve this current problem. Methodology The research paper will evaluate current provisions of the Corporations Act that support phoenix activity as well as sections that could be changed to enforce against it. Also, the endeavors of regulatory bodies used to combat phoenix companies will be addressed. Structure of Paper The structure of the paper will begin with an overview of the reasons behind the creation of phoenix companies, as well as outlining current statistics of these types of companies in the Australian corporate sector. The current incentives directors have to engage in phoenix activity undetected are analysed and laws that do not make sense are identified. Furthermore, the plans and concerns of regulatory and legislative bodies are examined before the recommendations of further law reform are discussed. The Phoenix Company Definition Phoenix companies are the result of directors transferring assets out of a failing company into a new company of which they are also directors to avoid the failed company s unpaid debts to its unsecured creditors. Rationale for phoenix activity The phoenix company is a vehicle used to avoid paying creditors such as the tax office, State payroll, workers compensation and trade suppliers. The relative ease of company directors setting up phoenix companies are encouraged by the loopholes in the Corporations Act as are discussed below. It is a way for companies to shed all current debt, transfer all or most of its

4 2 assets into new company operated by the same directors (usually with a similar trading name) without the residual liabilities that are now left with the shell company. Phoenix companies are intended to deny unsecured creditors equal access to the entity s assets in order to meet unpaid debts (PJC, 2004 p.131). Statistics Phoenix activity has always been present in the Australian corporate industry however it has only been recently recognised as a major problem facing the Government and corporate regulators. Research from the predecessor of ASIC, the Australian Securities Commission (ASC) has founded a growing concern on the impact that phoenix activity has on the economy (Coburn, 2003 p.2): The estimated loss to the economy due to phoenix activity is around $1.3 billion per annum 18% of all small to medium enterprises (SME s) have been affected by phoenix activities, which equates to around 9,000 individual companies per year. 80% of SME did not report dealings with phoenix companies, possibly due to market discretion i.e. informing the market that they have fallen victim and losing investor confidence. Phoenix companies tend to be small, with a maximum of two directors. By remaining small they can avoid investigation from liquidators by removing company property used to fund such litigation. The average phoenix company has paid up capital of less than $1,400 (Tomasic, 2003 p.2). Types of Phoenix Operators Horsington refers to the ASC findings of three types of phoenix operators; innocent, occupational hazard and careerist (2001 p.41). Innocent phoenix operators can arise from legal phoenix activity where the liquidator of a company will sell off the assets however they may be unique or specialised assets that have no apparent market so the old directors will register a new company and purchases the assets legally back from the old company. As long as the unpaid debt obligations are met by the company in liquidation, the transferring of assets into a new company with the same directors is lawful. The occupational hazard type of phoenix operator usually arises from the building and construction industry where small, single shareholder businesses are common. When business gets slow due to the seasonal operating periods of the economy, the director may register a new company with a similar trading name and sell its current assets to it for little or no consideration

5 3 then wind the old company up to avoid paying any outstanding employee entitlements, tax or other unsecured debts. This occurs mainly because it is the tradesmen s only method of receiving income therefore when business is slow the only way to stay in business is to operate in phoenix activity. Careerist phoenix operators build up debt then purposely wind up the company and start again. These types of offenders rely on professional advice from lawyers and accountants due to the increasing number of provisions in the Corporations Act that are in place to combat phoenix companies. The careerist will have a competitive edge over its rivals due to the fact that they will plan not to pay any debt and can easily transfer all assets out of reach from creditors and liquidators in the event of winding up. Case In January 2007, ASIC issued a media release informing the public of the director disqualification of Mr Nahi Gazal, a Sydney caravan manufacturer who was a director of six failed companies all carrying on the same business. All failed companies were wound up owing a total of more than $13 million to customers, secured and unsecured creditors. ASIC banned Mr Gazal from managing companies for the maximum period of five years under s506f (ASIC, ). Summary Phoenix companies are becoming more recognised as a major problem for regulators of the corporate industry. The extraordinary losses caused by phoenix companies every year have grabbed the attention of government regulators into pursuing those responsible. Currently the Corporations Act has many loopholes that encourage the use of phoenix activity and the fact that only 20% of cases are actually reported proves that the problem of phoenix companies won t be solved in the near future. Incentives of phoenix activity under the current Corporations Act Limited liability: Since the inception of corporate limited liability back in the 19 th century that encouraged commercial risk-taking, directors and investors have been protected by business failures to some degree. As companies become separate legal entities, their directors are hidden from personal liability otherwise known as the corporate veil. Phoenix operators exploit the original purposes of limited liability by deliberately avoiding their liability obligations and shielding themselves behind the corporate veil. This concept plays a large part in allowing phoenix activity to function in the current corporate sector as Courts are reluctant to challenge this principal of lifting the corporate

6 4 veil unless there are considerable stakeholders involved, whereas the majority of phoenix companies are SME s with little paid up capital. Liquidator to fund their own investigation into company failures Under s512, all expenses resulting in the proceedings of winding a company up are payable out of the property of the company which includes the liquidator s remuneration. Therefore, directors of phoenix companies can in fact remove the majority of assets out of the company leaving little or no available funds for a liquidator to investigate possible insolvent trading. Usually the amount of unsecured debt owed by phoenix companies is less than $5,000, which is not cost effective for a liquidator to instigate an examination into the insolvent trading provisions or any disqualification orders (Horsington, p.243). Under s545 (para.1) a liquidator is not obliged to incur any expense unless there is sufficient available company assets and/or property to reimburse such expenses. Therefore a company with little or no assets that is wound up is less likely to be investigated by the liquidator due to the fact that his/her expenses will not be reimbursed by company property hence the incentives of phoenix directors to asset strip their company before putting it into administration. The Parliamentary Joint Committee (2004, p.147) comments on the problem of companies with no available assets or property to fund an administrators investigation (assetless administration) which leads to a liquidator not being appointed and the company is ultimately wound up and deregistered. Phoenix directors know this and will purposely transfer assets out of the company to avoid a liquidator s investigation into how the company became insolvent and other breaches of the Act. Under s466 (4) any preliminary costs incurred from the application to wind up a company must be paid out of the property of the company. Additionally, s475 (para. 8) of the Corporations Act states that company property is to fund the preparation of preliminary reports of the company s affairs which is to be submitted to the liquidator at the commencement of liquidation. Defences for directors under s588h Under the current Corporations Act, there are several defences against the insolvent trading provisions of s588g company officers can rely on if they are accused of trading while insolvent, these include; Defence of reasonable presumption of solvency (para. 2) - when the debt was incurred, it was presumed that the company was solvent at the time and would remain solvent even when it occurred any other debts at that time.

7 5 Information that the company was solvent provided by a reliable person (para 3) - such as a professional accountant or financial advisor. Defence of illness (para. 4) - the company director because of illness did not take part in the running of the business. Defence of reasonable steps (para. 5) - the director took all necessary steps to prevent the company incurring any further debts. These actions can include the appointment an administrator and furthermore, at what point was the appointment of the administrator and what were the results of the appointment. Paragraph 5 of s588h creates a loophole that offers an opportunity for phoenix directors to evade prosecution under s588g as long as an administrator is appointed well before the company becomes insolvent. Allens Arthur Robinson (2007, p.238) states that if company directors suspect their company insolvent, the voluntary appointment of an administrator will avoid the compulsory appointment of a liquidator if there are minimal residual assets remaining in the company, thus minimising any investigations into breaches of the Corporations Act, namely s588g and director duty provisions. It is also possible that directors may appoint administrators that may act favourably to the company by not recommending the appointment of a liquidator. The director s defence of reasonable steps under s588h (5) can be overturned as in Plymin v ASIC (2003) 175 FLR 124; VSC 123. Mr Plymin and fellow director John Elliott, former directors of Waterwheel Holdings, were found guilty of insolvent trading under s588g through the declaration of contravention of s1317e that arises if the Court believes that a person has contravened certain civil provisions of the Act. Once these declarations are made, ASIC may then apply to the Court under s206c to disqualify the company officer(s) for a period decided by the Courts based on the severity of the contravention. In this case, the directors summoned an administrator however it was ruled that the appointment came far too late in the proceedings and were subsequently found personally liable for debts incurred while the company was insolvent. Transferring of assets Transferring assets to another company before liquidation is another incentive for managers to undertake phoenix activity. Under s588fe (para 4 & 6A), voidable transactions such as unreasonable and related party transactions are restricted by rules allowing the liquidator to reverse such antecedent transactions if they occur four years prior to the relation back-day. These provisions are effective in undoing the damage caused by insolvent trading however in analysing phoenix companies, the liquidator does not have the available resources to initiate any legal proceedings as the company property used to fund such litigation is transferred out long

8 6 before a liquidator is appointed. It is only when the liquidator has adequate resources to launch an investigation are the phoenix directors likely to be prosecuted. In relation to s588fe and voidable transactions, there are currently defences under s588fg that directors may use in defence of such offences. These provisions are similar to the defences under s588h relating to insolvent trading described above. Shadow control: When a company director transfers assets into a new company and subsequently deregistered the old company, it is possible to avoid breaching s206d and other director disqualification provisions by becoming a shadow director of the new company. It is quite legal for a phoenix director to appoint a friend, relative or spouse into a director s position in the new company and still retain control over the running of the new phoenix company (PJC, 2004 p.132). Potentially this cycle could continue repeatedly where shadow directors avoid being classed as directors every time a company is phoenixed. Business names register: Currently there is no restriction of registering a phoenix company s business name that is similar to its failed predecessor. It is entirely possible that unsecured creditors dealing with the latter company may continue to do business with the new phoenix company if the business names are very similar. There is no link between the ASIC Company Names database and the individual States register of trading names. The current process of registering a company should perform stringent checks on new companies bearing similar names to deregistered companies that have recently been wound up. Summary Currently there are numerous incentives that directors do have under the current Corporations Act to operate phoenix companies however the criminal and civil penalties of breaching such phoenix-related provisions such as insolvent trading (s588g), director duties (s ), disqualification of directors (s206d), avoiding employee entitlements (s596ab) and even reinstatement of deregistered companies to prosecute any outstanding claims (s601ah) all seem to outweigh any benefits. The combination of these provisions and other measures discussed further will greatly reduce the occurrence of phoenix activity in Australia. Methods of Combating Phoenix Activity outside of the Corporations Act Asset Administration Fund In 2005 the Assetless Administration Fund (AAF) was introduced by the Government and is managed by ASIC to finance the liquidator s preliminary investigations into failed companies that

9 7 have little or no assets. The purpose of the AAF is to allow liquidators to investigate failed companies and report any breaches of the Corporations Act to ASIC to initiate legal action. Previously, liquidators were only performing minimal enquiries into the reason of failed companies if there was a lack of company assets used to fund such investigations as liquidators are not required to incur any expenses above and beyond their statutory obligations. To be eligible to receive funding through the AAF, the liquidator must meet the following criteria (AAF, 2006 p.6-8); the liquidation must be assetless (ASIC considers assetless administrations with net realisable assets of less then $10,000) the initial s533 report must have been lodged (s533 relates to the liquidator s reports of any breaches of the Act made by company officers). the matter must be of a type ASIC may consider actioning (this includes any breaches of director s duties, insolvent trading and misappropriation of company property) there is or may be material or information available to support any allegations or concerns of the liquidator With the inception of the AAF, liquidators have the ability to examine failed companies and bring their management to account if the Corporations Act has been breached. There are positive results resulting from ASIC in the first three months of the 2007/08 financial year with 19 director disqualifications, 16 of them were phoenix related cases funded by the AAF (ASIC ). Since its inception there have been at least 164 applications for the disqualification of directors under s206f of the Act (Duns, 2007 p177). These results prove that phoenix activity if rife within the Australia corporate sector and it is the purpose of the AAF to fund preliminary investigations that widen the net to prosecute breaches of the Act. Maximum Priority rule The maximum priority rule is currently being considered by the Government to alleviate some of the current problems inherent with phoenix activity. The maximum priority rule would provide liquidators with the power to settle outstanding employee entitlements such as superannuation payments and long service leave with secured assets before the secured creditor s debts are paid. It is effectively changing the ranking of payments so that the employee s receive the first share of the liquidation proceeds. If this is the case, the secured creditors such as banks and other lending institutions will act sooner to secure their debt before the maximum priority rule applies upon liquidation and will closely monitor companies nearing insolvency. This will ultimately put increased pressure on directors to comply with their director duties nearing administration.

10 8 Injunctive relief There have been previous recommendations made by the Victorian Law Review Committee in 1994 for an injunction measure to restrict the transfer of company assets into a separate (phoenix) company before the liquidation process is entered into. This is similar to the injunction of insolvency in paragraph 1A(a) under s1324 of the Corporations Act and will result in company assets being frozen in the company leaving the liquidator with sufficient assets to fund further investigations or to pay any outstanding debts (Horsington, 2001p.243). Summary The introduction of the Assetless Administration Fund by the Government is an imperative step in fighting phoenix activity. The ability to give liquidators the opportunity to investigate such assetless administrations has already provided promising results. If further amendments to the injunctive relief provisions of the Act are passed, this will also greatly reduce the occurrence of phoenix activity by restricting the movement of such assets and effectively enabling the administrator to secure control over company property. The combination of these methods with selected provisions of the Corporations Act will reduce the ability for companies to avoid outstanding debt and force company directors to be accountable for their actions. Areas where law does not make sense Under s206d of the Corporations Act, the Court may disqualify a person from managing companies for up to 20 years if they are found to breach two conditions: first, the officer has managed two failed companies within a period of seven years and second; the way in which the companies were managed was wholly or partly responsible for the failure. Similarly, under s206f, ASIC has the power to disqualify a company officer for up to five years if the offender has managed two or more failed companies due to insolvency. As a result this current provision gives company director s free reign to engage in their first phoenix operation knowing that they cannot be disqualified under these sections of the Act. The Parliamentary Joint Committee in its 2004 report disagrees with this provision and recommends that the Court or ASIC should in its discretion, disqualify a person from being a director if the company has failed due to their misconduct. (PJC, 2004 p.144). The committee refers to ASIC and the Court s ability to recognise the difference between directors who act dishonestly or recklessly when managing a company and managers who happen to run a failing business that fall victim to the economic cycle.

11 9 Current law in need of reform There are some areas of the Corporations Act that need reform to further protect creditors of companies engaging in phoenix activity. Such areas include liquidator s own funding of investigations, tightening disqualification provisions, increase liquidators and administrators powers and introduce a directors liquidation bond. Liquidator s to fund own investigations Currently, the costs of investigations by a liquidator must be funded from the proceeds of sale derived from residual company assets under s512 of the Act. One of the main reasons why there are so many phoenix occurrences is that there are insufficient assets left in a failed company to allow liquidators to investigate the affairs of the company before it reached liquidation. Directors are encouraged by this provision to minimise any remaining assets to avoid prosecution from liquidators. The above mentioned provision should be changed to stipulate that liquidators are remunerated on a flat-fee basis by ASIC per case to cover initial expenditure of a preliminary investigation if there is insufficient company property remaining cover expenses. The liquidator should then file a report with ASIC detailing the reasons of winding up plus any breaches of the Act and recommendations, if any, for legal proceedings initiated either by the liquidator, ASIC or the Court. This recommendation is similar to the rationale behind the Assetless Administration Fund however I believe that every director of a company that enters the liquidation process should be accountable for any wrong-doing as generally it s the small unsecured creditors that are left with nothing after a phoenix company winds up. Disqualification of directors The disqualification of directors section 206D and 206F should be changed to allow a smaller scope of contravention of the Act. Company directors should be liable under s206d and 206F if they are officers of one (as opposed to the current provision of two) failed company and that it can be shown that the manner in which the corporation was managed was wholly or partly responsible for the corporation failing in a period of five (instead of seven) years. This is in support of the amendment suggested by the Parliamentary Joint Committee in 2004 however the Government has replied saying that phoenix activity typically involves two or more failures and has conceded that further legislative changes may be necessary if the current provisions are unsuccessful (Duns, 2007 p177).

12 10 Employee Entitlements Section 596AB concerns persons entering into agreements to avoid employee entitlements. Such transactions are can relate to phoenix company directors that deliberately avoid such payments, however under s596ac which cites that persons who contravene s596ab are liable to compensate for loss, paragraph 4 states, Proceedings under this section may only be begun within six years after the beginning of the winding up. This is a provision in the Act that forces former employees of liquidated companies to wait six years before entering into any proceedings under s59ac. This period should be reduced to allow a greater level of enforcement on those responsible as the majority of unsecured creditors cannot afford to hold on for so long to potentially receive an outstanding payment. Liquidator s powers Jones Condon, the insolvency practitioners firm recommends (2003, p6) that liquidators should have more powers to be able to retrieve any assets involved in antecedent transactions without receiving leave from the Court. If a liquidator believes that any voidable transactions have occurred up to a period of two years before the administration period, then he/she should be able to collect such assets, then the onus is then on the recipient to go to Court and prove that the asset should be returned. Administrator s powers I support the above recommendation due to the increased efficiency of the liquidator s investigations by reducing paperwork and number of court appearances. In addition to this, I suggest that administrators should have similar powers to the current liquidator s abilities, such as applying to Court to recover assets transferred from voidable transactions if it is suspected that director s duties of s of the Act are breached. Application of s588ff (1) (a) is described in Tolcher v National Australia Bank (2003) NSWSC 207 that the Court is empowered to make an order directing a person to pay to the company the amount of the voidable transaction. This would give administrators the ability to immediately act on the occurrence of phoenix activities if they are allowed to apply to Court to reverse such voidable transactions before appointing a liquidator, if after two creditor s meetings, one is approved. Generally when phoenix companies enter into administration there are insufficient assets to fund an investigation. If the administrator has reason to believe that company assets were transferred before entering administration then these assets could be recovered and further investigation would be warranted into additional breaches of the Act. Furthermore, phoenix directors have a defence against the insolvent trading provision s588g by means of appointing an administrator under s588h paragraph 6. If rogue directors decide to use this as a defence then the

13 11 administrator should be required to investigate and recover any assets transferred in antecedent transactions. Bond paid by directors I also support the recommendation made by the insolvency practitioners, Jones Condon (2003, p8) in relation to a specified bond paid by directors registering new companies to fund initial investigations if the company eventually ends up in liquidation. This would result in liquidators receiving the bond if the company goes into liquidation which permits the preliminary enquiries into administrations (especially if assetless) that would previously not be investigated. This bond would be returned to directors and shareholders if no outstanding debts are due after deregistration. Summary Increasing the current powers of administrators and liquidators to initiate injunctive measures that will limit the transfer of assets through estoppel will greatly affect the prevention and detection of phoenix companies. In addition the liquidators bond will also be a benefit if a liquidator has insufficient company assets to fund an investigation or is not eligible to receive funding from the AAF. A positive factor in relation to the suggested reforms is that the core provisions are already in place and it is just a matter of changing certain subsections that will greatly affect the overall regulation and prosecution of phoenix company directors. Main Conclusion There are several provisions in the current Corporations Act that require reform in respect to preventing the occurrence of phoenix activity however there are effective penalties and retrospective laws that outweigh the loopholes. The current legislation only needs minor reforms if cases of phoenix activities reach the attention of the liquidators and regulators. The main problem is identifying phoenix companies before they rise due to the elusiveness of rogue directors before putting the company into administration. Overall the Corporations Act is acceptable in its provisions relating to phoenix companies, as unfortunately, the current burden falls on the liquidators who tend to only meet their minimal statutory requirements and refuse to incur any additional expenses to initiate legal proceedings. I believe that the prevention and prosecution of phoenix companies and their directors will increase if the issue of liquidator s remuneration is addressed.

14 12 Bibliography 1. Allens Arthur Robinson. 2007, Director s Duties During Insolvency. 2nd Edition, Sydney Wales: Lawbook Co. 2. Coburn, Niall Coburn s Insolvent Trading: Global Investment Fraud & Corporate Investigations. 2 nd Edition, Sydney: Lawbook Co. 3. Corporations Legislation, 2007, Sydney: Thomson Lawbook Co. 4. Horsington, Helen Director s Duties During Insolvency. Sydney: Lawbook Co. 5. Lipton, P. & Herzberg, A Understanding Company Law. New South Wales: Lawbook Co. Electronic Sources 6. ASIC bans Sydney caravan operator, 2007, ASIC Media Release, (accessed 8 th September 2007) 7. ASIC Disqualifies Six Directors, 2007 ASIC Media Release, (accessed on 15 th October 2007). 8. Assetless Administration Fund: Funding Criteria & Guidelines, 2006, ASIC, und_guide_stage2.pdf, (accessed 8th September 2007) 9. Coburn, Niall, 1998, The Phoenix Reexamined, Australian Journal of Corporations Law, 8 (10): T &format=GNBFULL&sort=BOOLEAN&startDocNo=1&resultsUrlKey=29_T &cisb=22_T &treeMax=false&treeWidth=0&csi=267866&docNo=1 (accessed 8 th October 2007 from LexisNexis AU) 10. Duns, John. Deterring officer misconduct: The impact of the proposed insolvency reforms on company officers, 2007, Insolvency Law Journal 15: hit-j.htm$global=g_$g_has_query=true (accessed 6th October 2007) 11. Goldman, David. Directors beware! Creditor protection from insolvent trading, Company & Securities Law Journal, 23: _POUNDSIGN=LPHit1 (accessed 6 th October 2007 from Lawbook Online) 12. Martin, Angela, 2007, Director s Duties & Phoenix Companies, Sydney: Allens Arthur Robinson, (accessed 10th October 2007)

15 Parliamentary Joint Committee on Corporations & Financial Services, 2004, Corporate Insolvency Laws: A Stocktake, Canberra: Commonwealth of Australia, (accessed 6th October) 14. Plymin v ASIC (2003) 175 FLR 124; VSC 123, (accessed 9th October 2007) 15. Submission 12, 2003, Jones Condon Chartered Accountants Jones Condon submission 12 (accessed 15th October 2007) 16. Tolcher v National Australia Bank (2003) NSWSC 207, (accessed 9th October 2007) 17. Tomasic, Roman, Developments and Events: Phoenix Companies & Corporate Regulatory Challenges, 2003, Australia Journal of Corporations Law, 6 (10): T &format=GNBFULL&sort=BOOLEAN&startDocNo=1&resultsUrlKey=29_T &cisb=22_T &treeMax=false&treeWidth=0&csi=267866&docNo=3 (accessed on 9 th October 2007 from LexisNexis)

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