LATENT DEFECTS IN PHOENIX LEGISLATION

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1 LATENT DEFECTS IN PHOENIX LEGISLATION What is phoenix activity? Phoenix activity is not defined in Australian legislation. 1 Perhaps this is not surprising given that the term is notoriously difficult, if not nearly impossible to precisely define. 2 In fact, a study conducted by the International Association of Insolvency Regulators (IAIR) revealed that no jurisdiction within the association was able to categorically define phoenix activity, although they all acknowledged it was a problem. 3 Notwithstanding this, definitions of phoenix activity have evolved from various parliamentary reports, papers and inquiries. Probably the most noteworthy, in the context of the building and construction industry, is the Royal Commission into the Building and Construction Industry 4 (Cole Inquiry), which originally adopts the definition 5 of the Australia Securities Commission (as it then was). Phoenix activity has been described as the concept: and where business operations are transferred from one company to another to avoid having to meet liabilities to unsecured creditors (particularly revenue authorities and employees). 6 the evasion of tax and other liabilities, such as employee entitlements, through the deliberate, systematic and sometimes cyclic liquidation of related corporate trading entities. 7 1 Corporations Act 2001 (Cth). 2 The Parliamentary Joint Committee on Corporations and Financial Services, Parliament of Australia, Corporate Insolvency Laws: A Stock take (2004), Appleby, P. The regulation of phoenix companies: Collective Responses of a Survey of Members of the International Association of Insolvency Regulators, 29 October Commonwealth, Royal Commission into the Building and Construction Industry, Final Report (2003) ( Cole Inquiry ). 5 ASC Research Paper, Phoenix Companies and Insolvent Trading, No. 95/01 (July 1996) p1; phoenix activity is defined as a company that fails and is unable to pay its debts; and acts in a manner which intentionally denies unsecured creditors equal access to the available assets in order to meet and pay debts; and within 12 months of closing another business commences which may use some or all of the assets of the former business, and is controlled by parties related to either the management or directors of the previous company. 6 Insolvency Reform package released by the Treasury dated 12 October Treasury (2009), Action against fraudulent Phoenix Activity: Proposals Paper, page 5.

2 The recurring theme seems to be the stripping of assets from the failed company to the new company to avoid paying liabilities. A recent example of phoenix activity was considered in Australian Securities and Investment Commission v Somerville & Ors 8. In that case, the Supreme Court of New South Wales found a solicitor guilty of aiding and abetting directors to breach their duties by engaging in asset stripping or phoenix activity, by, inter alia, transferring assets from a failed company to a new company without consideration and all existing debts from the old company remained with it. Who is affected? Feedback from various stakeholders indicates that phoenix activity is a significant problem in the building and construction industry. It is considered a medium to high risk industry. 9 According to the Construction, Forestry, Mining and Energy Union and the Australia Taxation Office, phoenix activity is most prevalent in the industries which have large workforces of unskilled or semi unskilled labour and where labour costs are significant to the operation of the business. 10 Interestingly, the type of industries which have been identified include formworking, scaffolding, concreting, bricklaying, plastering, gyprock fixing, steel-fixing and to a lesser extent plumbing. 11 Typically, the activity usually involves non-payment of group tax (PAYG (withholding)), state payroll tax superannuation, long service leave contributions, and workers compensation premiums. 12 At what cost? Phoenix activity is estimated to cost the federal government $600 million per year 13, adversely impact on businesses somewhere between $0.99 and $1.93 billion 14 and affects employees in the order of $126 million. 15 Another report commissioned by the Fair Work Ombudsman, found that phoenix activity costs the Australian economy between $1.78 billion and $3.19 billion a year. 16 However, these figures ought not to be held conclusive because quantifying the costs of phoenix activity is inherently problematic primarily because there is no precise 8 [2009] NSWSC PWC, Phoenix activity Sizing the problem and matching solutions, (2012). 10 Cole Inquiry. 11 Cole Inquiry, 115, para Cole Inquiry, 115, para Treasury 2009 (November 2009), Action against fraudulent Phoenix Activity: Proposals Paper, page PWC, Phoenix activity Sizing the problem and matching solutions, (2012), 25; Barlow, Darren 1996, Phoenix Activities and Insolvent Trading, PWC, Phoenix activity Sizing the problem and matching solutions, (2012), PWC, Phoenix activity Sizing the problem and matching solutions, (2012), 22. 2

3 definition. 17 Needless to say, very few countries are able to provide definitive metrics on the incidence of phoenix activity 18 but there is a general recognition that it poses a real financial problem. 19 What are the recent legislative attempts to crack down on phoenix activity? On 20 December 2011, the Federal Government released two exposure drafts of legislation to crack down on phoenix activity being the Phoenixing Act which came into force on 1 July and the Similar Names Bill, which has not been passed yet and there is no indication when or if it will. Phoenixing Act The Phoenixing Act amends the Corporations Act to give the Australian & Securities Investment Commission (ASIC) a discretionary power to wind up an abandoned company in certain circumstances. 21 Those circumstances are prescribed in s489ea of the Corporations Act 2001 (Cth). 22 According to the Explanatory Memorandum 23 to the Phoenixing Act, one of the aims of the Act is to assist employees of companies abandoned by their directors, to 17 Murrary Roach, Combating the Phoenix Phenomenon: An Analysis of International Approaches (2010), ejournal of Tax Research (2010), Vol 8, no 2, Murrary Roach, Combating the Phoenix Phenomenon: An Analysis of International Approaches (2010), ejournal of Tax Research (2010), Vol 8, no 2, Appleby, P. The regulation of phoenix companies: Collective Responses of a Survey of Members of the International Association of Insolvency Regulators, 29 October Corporations Amendment (Phoenixing and Other Measures) Act Regulatory Guide 242: ASIC s power to wind up abandoned companies, January 2013, p4, Reg Briefly, those circumstances are the company has not responded to a return of particulars, or lodged any other documents with ASIC under the Corporations Act in the last 18 months, which leads ASIC to believe that the company is not carrying on business and that making the order is in the public interest; the company s review fee has not been paid in full at least 12 months after the due date for payment; ASIC has reinstated the registration of the company in the last 6 months of when it became due and believe that making the order is in the public interest; ASIC believe that the company is not carrying on business and have given the company an opportunity to object to the wind-up, which no objection was received. 23 Explanatory Memorandum, Corporations Amendment (Phoenixing and other Measures) Bill 2012 (Cth). 3

4 receive payments from the General Employee Entitlements and Redundancy Scheme (GEERS) 24 more expeditiously. ASIC has issued Regulatory Guide 242, which explains in broad terms when it will exercise its powers under Part 5.4C of the Corporations Act 2001 (Cth). Importantly, ASIC is not required to exercise its power in every situation. 25 In determining whether or not to exercise its power to wind up an abandoned company, ASIC will generally consider two things. First, the primary consideration is to identify whether the company is abandoned. 26 Second, if the primary consideration is met, then ASIC will consider: whether there is a creditor capable of winding up the company; 2. whether sufficient time has passed for the creditor to take its own action; 3. the cost of liquidation compared to the amount of the employee entitlements claimed; 4. Whether or not there is a current business operation and the amount of money available in the Assetless Administration Fund (AA Fund). 28 ASIC must, however, publish notice of its intention to make the order on the ASIC database 29. No order can be made by ASIC if there is an application before the Court to wind up the company. However, once ASIC makes the order to wind up the company, it may appoint a liquidator and the winding up proceeds as a creditors voluntary winding up GEERS is a scheme funded by the Australia Government to assist employees who have lost their jobs due to the liquidation of their employer and who are owed employee entitlements. GEERS was replaced by the Fair Entitlements Guarantee Act 2012 which commenced on 5 December Regulatory Guide 242: ASIC s power to wind up abandoned companies, January 2013, p4, Reg Regulatory Guide 242: ASIC s power to wind up abandoned companies, January 2013, p6, Reg Regulatory Guide 242: ASIC s power to wind up abandoned companies, January 2013, p6, Reg The AA Fund was established by the Federal Government and is administered by ASIC. It finances preliminary investigations and reports by liquidators into the failure of companies with few or no assets, where it appears that enforcement action may result from the investigation and report. A particular focus of the AA Fund is to curb fraudulent phoenix activity. 29 Corporations Act 2001 (Cth), s489ea(6). 30 Corporations Act 2001 (Cth), s489eb. 4

5 If ASIC orders a company be wound up under s 489EA of the Corporations Act 2001 (Cth), it may appoint a liquidator for the purpose of winding up the affairs and distributing any property of the company. 31 Similar Names Bill The Similar Names Bill provides that a director of a failed company can be jointly and individually liable for the debts of a new company that has a similar name to a pre-liquidation name of the failed company. 32 There are also certain time restrictions specified. 33 The common directors are liable for the debts of the new incorporated entity 34, unless: 1. they are exempt by order of the court 35 ; or 2. by determination of the liquidator of the failed company 36 ; or 3. the new company was carrying on business under the same/similar name to the failed company during the 12 month period prior to the failed company being wound up 37 ; or 4. the failed company has paid its debts in full Corporations Act 2001 (Cth), s489ec. 32 Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s596aj. 33 The director must have been a director of the failed company within the twelve month period preceding the failed company s winding up as well as be a director of the phoenix company when the phoenix company s debt was incurred, which must occur within five years from the commencement of the failed company s winding up. See Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s596aj(1)(b) and (d); 34 Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s596aj(2). 35 For instance, where the person has acted honestly and having regard to all the circumstances of the case; see Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s 596AK. 36 The liquidator can have regard to the assets of the failed company and the assets of the new company in making a determination; see Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s596al(1). 37 Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s596am. 38 Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s596an 5

6 According to the Explanatory Memorandum 39 to the Similar Names Bill, the purpose of the Bill is to target phoenix activity where a director seeks appointment to a similarly named company to the failed company, so as to create the impression that the similarly named company is a continuation of the failed company. Evaluate the effectiveness of the legislative attempts When the Phoenix Bill and Similar Names Bill exposure drafts were released in 2011, the then Secretary to the Treasurer, the Honourable David Bradbury, made a number of claims about the effectiveness of the proposed legislation. 40 For the reasons articulated below, those claims are arguably ambitious and perhaps not justified. Phoenix Act The discretionary power given to ASIC to place a company into liquidation in certain circumstances is certainly beneficial for a few reasons. First, it reduces costs and speeds up the liquidation (by removing the need to file an application). 41 Second, the liquidator can then investigate and if necessary, take appropriate action against directors more quickly for breaches of director s duties or claw back voidable transactions. 42 Third, liquidation allows employee s access, in certain circumstances, to either GEERS or payment of employee entitlements under the Fair Entitlements Guarantee Act 2012 (Cth). However, the legislation arguably does nothing to improve the outcomes for ASIC, employees or other unsecured creditors. 43 First, it does not define the difficult question, what is phoenix activity, although it does set out some circumstances which might easily be avoided by directors. While this paper recognises the difficulty with defining phoenix activity, the legislature 39 Explanatory Memorandum, Corporations Amendment (Similar Names) Bill 2012 (Cth). 40 Hon David Bradbury said that the amendments will stop directors from exploiting the limited liability protections in the corporations law to avoid having to pay any debts including workers entitlements, that they incur in a phoenix company and will stop directors form racking up debts through phoenix companies. He also said that the proposed amendments would crack down on phoenixing where directors try to avoid paying workers entitlements by restarting using their failed business by using a similar company name; see David Bradbury, Gillard Government Releases Draft Laws to Crack Down on Phoenixing (Media Release, No 66, 20 December 2011). 41 Helen, Anderson, The Proposed Deterrence of Phoenix Activity: An Opportunity Lost? (2012), 34, Sydney Law Review, 411, See for example Corporations Act 2001 (Cth) s 588FB (uncommercial transactions) and s 588FDA (unreasonable director related transactions). 43 Helen, Anderson, The Proposed Deterrence of Phoenix Activity: An Opportunity Lost? (2012), 34, Sydney Law Review, 411,

7 ought to prescribe indicia to help identify it and bring some certainty about the issue. A good starting proposition might be the various definitions of phoenix activity. Otherwise, directors of failed companies might be discouraged from starting a new venture for fear of prosecution or uncertainty. Many failed entrepreneurs have succeeded after bankruptcy 44 and therefore the regime must not be too prohibitive so as to stifle growth in business. Some commentators have said that it is helpful to discern phoenixing activity from honest business failure and perhaps this is another way to assist to formulate a definition. 45 Second, the power bestowed on ASIC is discretionary. Therefore, even though an employee may be owed entitlements, ASIC can refuse to exercise its power. 46 Given the factors prescribed in the Regulatory Guide 242 for ASIC to consider, it is reasonable to infer that the restraints are likely due to funding and resource issues. Perhaps to extend the ambit of the legislation, ASIC might consider either introducing an annual levy on all companies or alternatively, increasing company annual review fees or fees paid on documents filed by the company. That money could be used to top up the Assetless Administration Fund (AA Fund) 47 to assist with investigations and prosecutions of directors who have been opportunistic at the detriment of creditors or employees. Third, the Phoenix Act does nothing to actively discourage phoenix activity. The legislature ought to consider bestowing authority on ASIC to investigate companies they suspect are engaging in phoenix activity by performing audits on high risk industries in the building and construction industry. They might be given similar powers to the Australian Taxation Office (ATO) to investigate issues and issue penalties against directors and perhaps detect any early symptoms of phoenix activity. There should also be a national register of directors who have been the 44 Henry Ford (who perfected the production line); Walt Disney (entertainment); Charles Goodyear (investor of the rubber tyre). 45 Murrary Roach, Combating the Phoenix Phenomenon: An Analysis of International Approaches (2010), ejournal of Tax Research (2010), Vol 8, no 2, Regulatory Guide 242: ASIC s power to wind up abandoned companies, January 2013, p6, Reg In October 2005, ASIC was allocated $23 million over four years by the Federal Government to establish the AA Fund. It finances preliminary investigations and reports by liquidators into the failure of companies with few or no assets, where it appears to us that enforcement action may result from the investigation and report. A particular focus of the AA Fund is to curb fraudulent phoenix activity; See Australian Securities and Investments Commission, Assestless Administration Fund ASIC (online), 24 October 2013 < 7

8 subject of adverse reports so that ASIC and the ATO can monitor their business interests. Consequently, the Phoenix Act appears to be an improvement in form rather than substance 48 and certainly falls short of the claims made by the Honourable David Bradbury. Similar Names Bill The Similar Names Bill is not without its limitations. Some critics point out that that the proposed legislation does nothing to prevent phoenix activity and it merely addresses the symptoms. 49 The Similar Names Bill is problematic for three reasons. First, it does nothing to prevent the incorporation of a new company with a similar name to the failed company where the related party of a director of the failed company is appointed, such as a spouse, sibling or child. 50 A good illustration of this problem is evident in the case study of Emerson Industries, referred to in the Cole Inquiry. 51 In that case, Mr Harkin, a bankrupt and director of a failed company called Emerson Services Pty Ltd, had his spouse incorporate and become a director of a company named ACN Pty Ltd trading as Emerson Services, which essentially continued with the contracts of the failed company. Under the proposed Similar Names Bill, Mr Harkin would escape personal liability. This is a serious limitation of the proposed Similar Names Bill. Perhaps a more robust and realistic test is to make directors personally liable if they are carrying on the same or substantially the same business as the failed company 52 and also have it extend to the directors extended family. For instance, the court might take into consideration, amongst other things, the relationship of the new director and director of the failed company, the structure of the failed and new company, the resources used, the customers, the nature and name of the business, the premises used, and the staff employed. 48 Helen, Anderson, The Proposed Deterrence of Phoenix Activity: An Opportunity Lost? (2012), 34, Sydney Law Review, 411, Office of Minister of Commerce (2003), paragraphs Helen, Anderson, The Proposed Deterrence of Phoenix Activity: An Opportunity Lost? (2012), 34, Sydney Law Review, 411, Cole Inquiry, Mark McKillop, Proposed Law on Phoenix Activity Falls Flat (online), 5 March 2012, < 8

9 There should however, be a defence available to the directors of the new company if they can establish, on balance, that they paid fair market value for the assets of the failed company. Further, directors who act honestly and without the intention of seeking to avoid paying creditors can apply to the Court, or to the liquidator of the failed company to seek that they be exempt from liability. 53 A possible way to monitor affiliated directorships (in terms of relatives or partners of the directors) is for directors to nominate the names of their spouses and/or siblings on ASIC forms so that data matching information might be used by authorities to see if new directorships are started which are engaged in similar business to that of the failed company. Administratively, this could be achieved by a form filled in by the directors, and then each year at the company renewal, a statement should be distributed to directors about their associates and asked to confirm if they are still accurate. This proposed amendment might improve the effectiveness of the proposed legislation by preventing failed directors from using family associates to run a new business based on the failed business without paying their liabilities. Second, the Similar Names Bill does not impose any liability on directors for the debts of the failed company, only the debts of the new company 54 and only if that new company is not carrying on business. 55 The effect of this appears counterintuitive because it does not satisfy the creditors of the failed company. It appears that the legislature have based the Similar Names Bill on legislation in the United Kingdom 56 and New Zealand. 57 The legislature ought to consider amending the provision to also capture the debts of the failed company, unless of course, the directors can demonstrate that they paid fair market value for the assets. Third, the penalty is a civil penalty provision only 58, which may not deter directors. The legislature should seek submissions about making the penalty criminal in circumstances where directors have a history of phoenix activity. This might be facilitated by a serial offender national register which can be used by authorities to monitor directors. Although, a similar concept has been considered in other jurisdictions, such as Canada, it has not been widely supported for a variety of 53 Similar provisions to Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s 596AK(3) may be implemented. 54 Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s 596AJ(1). 55 Corporations Amendment (Similar Names) Bill 2012, Schedule 1, item 1, inserting Corporations Act s 596AM(1)(b). 56 Companies Act 2006 (UK). 57 Companies Act 1993 (NZ). 58 Similar Names Bill Schedule 1, item 1, inserting Corporations Act, s 596AJ(1). 9

10 reasons, including stifling business. 59 Conversely, other commentators believe there is utility in the incorporation of a disqualification scheme, commenting that the director disqualification scheme in the UK has had more success (in terms of reducing the occurrence of phoenix activity) in protecting creditors than jurisdictions without the measure. 60 Problems common to the Phoenix Act and Similar Names Bill The Phoenix Act and the Similar Names Bill have no application when the company is placed into voluntary administration and revived by a Deed of Company Arrangement (DOCA). 61 Although the DOCA is voted on by the creditors 62, a potential issue of injustice may arise where the majority of creditors are in fact the directors or related parties and vote in favour of the DOCA, perhaps to the detriment of other creditors. This situation is often seen in small family owned companies. 63 Although, upon an application, a creditor can apply to the court to set aside the decision of the second creditor s meeting on the DOCA 64 where the outcome has been determined by votes cast by related parties, it is seldom used by small unsecured creditors because of the expense and time involved. Consequently, unless major unsecured creditors like the ATO use the application, it is rarely used. The legislature should consider reversing the onus of proof for an application under s 600A of the Corporations Act 2001, whereby there is a rebuttable presumption that the director has not acted fairly in voluntary administration where the majority of the votes cast were by related entities. 59 Bomhof, S, Canada: Duties of Directors in the Insolvency Zone, Mondaq Business Briefing, 21 October 2009, p Girgis, J. Corporate Directors Disqualification: The New Canadian Regime? Alberta Law Review, Vol. 46, No 3, 2 July Helen, Anderson, The Proposed Deterrence of Phoenix Activity: An Opportunity Lost? (2012), 34, Sydney Law Review, 411, Corporations Act 2001 (Cth), s 439C(a). 63 Ben Butler, Fury as Nursery to Repay Only 6cents in Dollar Sydney Morning Herald (online), 11 January 2012 < 64 Corporations Act 2001 (Cth), s 600A; See also Deputy Commissioner of Taxation v Woodings (1994) 13 WAR 189 for an example of this section being successfully used. 10

11 1. post studies of bankruptcy performance in the United States found that a significant number of businesses require a restructure again either through private intervention or through a second or third liquidation. 65 These issues pose some challenging problems. The real question is, will the reorganisation model, on balance, improve the return to creditors and minimise phoenix activity within Australia? There is utility in assisting creditors to take control and reorganise a failing company to protect their interests and preserve the overall value for creditors. The intended rationale behind the reorganisation model is that if you give the company back to the directors, then in theory, they are less inclined to syphon off the assets and therefore reduce the incidence of phoenix activity. 66 However, there is no evidence to suggest this is in fact the case, and therefore submissions ought to be sought from various stakeholders about the reorganisation model. The legislature might consider a revised reorganisation model by holding directors of the failed companies personally liable if the company fails a second time, or alternatively, require the directors to offer some form of security before the court will sanction any reorganisation. The biggest loser in phoenix activity is creditors. 67 Therefore, giving creditors an opportunity to preserve their interest either by selling the failing business as a going concern or swapping debt for equity ought to be given serious consideration by the legislature. 65 Altman, Edward I, and Edith Hotchkiss (2006), Corporate Financial Distress & Bankruptcy, 3 rd edition. John Wiley, Hoboken. NJ. 66 Murrary Roach, Combating the Phoenix Phenomenon: An Analysis of International Approaches (2010), ejournal of Tax Research (2010), Vol 8, no 2, PWC, Phoenix activity Sizing the problem and matching solutions, (2012), 25; Barlow, Darren 1996, Phoenix Activities and Insolvent Trading,

12 Boss Lawyers 17 March 2014 Disclaimer This article is not legal advice. It is general comment on the law only. You are instructed not rely on the commentary above unless you have consulted one of our lawyers to ascertain how the law applies to your particular circumstances. 12