Winners & Losers What is the future for corporate insolvency in Australia?

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1 Winners & Losers What is the future for corporate insolvency in Australia? Tim Somerville Partner, Somerville Legal February 2012 The opinions expressed in this whitepaper are those of the author and not necessarily the opinions of LexisNexis Pacific.

2 Introduction In recent times, the collapse of such companies as HIH have emphasised the destructive impact of corporate insolvency, not only on companies as a whole but also on their employees, share holders, creditors and tax payers. Tim Somerville explores these impacts and the role of liquidators, as part of the government s responses to the problems.. Background On 4 January 2012, the Australian Securities and Investments Commission (ASIC) published statistics showing how little creditors receive from companies in liquidation. This comes two years after Nationals Senator John Williams told the Senate of the human and financial tragedy caused by the collapse of the Australian financial services provider, Storm Financial in early This led to the Senate appointing a committee to look into the insolvency industry, which reported in September This paper considers the objectives of the Australian corporate insolvency system, whether it is meeting those objectives and what can be done to solve the problems. In particular, the recommendations of the Senate inquir y and their effect on corporate insolvency in Australia will be examined. Is the corporate liquidation system meeting its objectives? The website of the Australian Securities and Investments Commission (ASIC) states: The purpose of liquidation of an insolvent company is to have an independent and suitably qualified person (the liquidator) take control of the company so that its affairs can be wound up in an orderly and fair way for the benefit of creditors. 3 Is the system working for the benefit of creditors? Companies often have secured creditors, such as banks and finance companies, who hold a mortgage or charge over company assets. They are not the creditors who need help. The victims of company liquidation are the unsecured creditors, referred to in this paper as ordinary creditors. They are generally the employees or suppliers of the failed company. 1 Sen John Williams, Opinion Piece (2011) < - piece&catid=26:media&itemid=176> at 17 August Senate Economics Reference Committee, The regulation, registration and remuneration of insolvency practitioners in Australia: the case for a new framework (2010) Parliament of Australia < > at 17 August ASIC, Information Sheet 45 (2008) <http://www.asic.gov.au/asic/pdflib.nsf/lookupbyfilename/liquidation_guide_for_creditors.pdf/$file/liquidation_guide_for_credi tors.pdf> at 17 August

3 The following table shows how many of the companies under external administration made payments to the ordinary creditors. 4 Estimated cents in the $ dividend to unsecured creditors c 11 20c 21 50c c Australian Capital Territory New South Wales Northern Territory Queensland South Australia Tasmania Victoria Western Australia International Total According to the table, unsecured creditors of over 92% of the companies will receive nothing. In fact, ordinary creditors of over 99.2% of the companies will receive less than 50 cents in the dollar. Clearly, this system is not operating in the interests of the ordinary creditors. The winners There are no detailed statistics available on how much liquidators earn. Some published reports about particular companies give some insight, many showing multimillion dollar payments to liquidators. There are also countless smaller liquidations, where all of the company s money and assets (other than money for secured creditors) go to the liquidator. Where do the countless millions of dollars paid to the liquidators come from? 4 ASIC, Australian insolvency statistics (2011) < pdf/$file/Insolvency-stats-series-1-issued-August-2011.pdf> at 17 August

4 The losers 1. Creditors Virtually all the money paid to liquidators comes from the companies money, money which would otherwise go to the creditors. In other words, it is the creditors who pay the fees taken by liquidators. However, they are not the only losers. 2. Creditors of creditors Where a company goes into liquidation, with nothing paid to creditors, this can cause unpaid creditors also to become insolvent and end up in the hands of liquidators. 3. The taxpayer The largest loser from Australian corporate insolvency is the Australian taxpayer. Payment of liquidators fees. The Australian Tax Office (ATO) is a large unsecured creditor of most companies going into liquidation. In effect, the Australian taxpayer is footing the bill for a large percentage of the fees taken by liquidators. Tax losses Creditors of failed companies claim a tax deduction for their bad debts. How much more tax would be collected if the money and assets of the companies taken by the liquidators went to ordinary creditors? Preferences Payments to creditors in the 6 months before the commencement of the winding up must be paid back to the liquidator, subject to certain exceptions. A large percentage of these payments collected by liquidators come from the ATO. There are no published detailed figures, but the amounts involved are many millions of dollars. The GEERS scheme The General Employee Entitlements and Redundancy Scheme (GEERS) is a government payment to employees for unpaid entitlements from failed companies. Since its inception, it has cost the Australian government the better part of one billion dollars. If money otherwise payable to employees were not taken by liquidators, there would be hu ge savings to the Australian taxpayer. Again, no detailed published figures are available to calculate this loss. Incentives not to pay tax Insolvency law strongly encourages company directors not to try to pay the tax owed by the company. Company directors are personally penalised for making payments of tax from a struggling company and for trying to trade their way through financial difficulty. 4

5 The mystique of the liquidator Under s 532 of the Corporations Act, only registered liquidators can liquidate insolvent companies. Also, once you appoint a liquidator, you cannot disengage them, without an expensive court case. 5 This raises a number of questions. Why should these special rules apply to this exclusive club? Why can t any chartered accountant liquidate an insolvent company? Why can t a liquidator be removed from the case? The liquidators response is that the system is so complex that only they have the specialised knowledge to be trusted with the job. However, modern technology makes the application of the insolvency laws readily available to any accountant or lawyer. The laws on insolvency are far simpler than the tax laws which chartered accountants deal with every day. Liquidators fees Liquidators generally charge according to hourly rates set b y each individual liquidator. The following chart shows the rates charged by a typical firm. 6 However, some charge much more. Classification Hourly Rate (excl. GST) Description Partner Registered liquidator or bankruptcy trustee. Brings his or her specialist skills to the administration or insolvency task. Director Typically CA or CPA qualified with in excess of 10 years experience on insolvency Director matters with a number of years at manager level. Answerable to the appointee but otherwise responsible for all aspects on an administration. Capable of controlling all aspects of an administration. May be appropriately qualified to take appointments in his/her own right. Manager Typically CA or CPA qualified with 6 to 8 years experience working on insolvency Manager matters. Will have experience conducting administrations and directing a number of staff. Senior Analyst Typically completed or near completion of CA or CPA qualifications with 4 to 6 years Senior Analyst insolvency experience. Assists in planning and control of smaller matters as well as Senior Analyst performing some more difficult tasks on larger matters. Analyst Typically studying towards CA or CPA qualification with 2 to 4 years insolvency Analyst Analyst Graduate experience. Works under supervision of more senior staff in performing day -to-day fieldwork. Support A Generally a person currently undertaking a university degree. Works under Support B supervision in providing assistance on tasks involved in insolvency matters. Vacationer ss 473, 503, 536, Corporations Act 2001 (Cth) 6 Richard J Hughes and John L Greig, Guidance to Creditors on Remuneration (9 March 2009) Deloitte Touch Tohmatsu (2009) <http://www.deloitte.com.au/media/docs/au_deloitte_lexicon_gadsden_circular.pdf >. 5

6 However, the main issue is with the number of hours recorded. In the HIH meltdown, one firm of liquidators was appointed to liquidate all of the Australian companies. Fees up until August 2005 are shown in the following table. 7 Company HIH Casualty & General Insurance Limited Liquidators Liquidators fees fees paid unpaid $22,043,549 $885,019 Total Liquidators fees $22,928,568 FAI General Insurance $13,869,656 $630,649 Co Limited $14,500,305 CIC Insurance Limited $4,450,097 $134,565 $4,584,662 World Marine & General Insurances Pty Limited $204,075 $135,156 $339,231 FAI Traders Insurance Co Limited $10,340 $24,187 $34,527 FAI Reinsurances Pty Limited Nil $24,274 $24,274 FAI Insurances Limited $1,195,098 $54,925 $1,250,023 HIH Underwriting & Insurance (Australia) Pty Limited $13,517 $40,193 $53,710 Total $41,786,332 $1,928,968 $43,715,300 The total of over $43m assuming an average rate of $200 per hour would equal a person working for 40 hours per week for 114 years. The need for liquidators There are two sides to every story. While creditors feel aggrieved that their money is going to pay liquidators fees, liquidators are a vital part of the insolvency regime under the Corporations Act. For simplicity, insolvency practitioners are referred to in this paper as liquidators whether acting as administrators, receivers or liquidators. In all of these roles, they are an essential part in the way the law deals with insolvent companies. Deeds of company arr angements A deed of company arrangement (DOCA) is an agreement binding on an insolvent company and its creditors, under which payments are proposed to be made to the cr editors, usually by the company continuing to trade. The DOCA is proposed by the liquidator and adopted by a meeting of creditors. DOCA s can give real benefits to creditors, compared to liquidation. As soon as the DOCA is signed, the company is generally handed back to the directors. Provided they generate the money to pay the liquidator s fees and the part payments to creditors required by the DOCA, they can then continue to run the company in the future. 7 McGrath Nicol and Partners, Form 524 Presentation of Accounts and Statement by Liquidator (For the period ended 26 August 2005) <http://www.hih.com.au/pdf/3_appendixes%20to%20australian%20explanatory%20statement.pdf >. 6

7 There are many companies still in business today, after going through the DOCA process. Those companies would be out of business, if they had simply gone into liquidation. The creditors of these companies often receive more than they would have received under a liquidation. The Corporations Act requires a liquidator to act as administrator of the funds collected under the deed. 8 Preventing insolvent trading It is clearly in the interests of the community to stop companies trading while insolvent. Otherwise, they continue to run up debts to creditors, who may never be paid. It is illegal for directors to allow a company to continue to trade while insolvent. 9 However, many directors ignore this as they refuse to face the reality that their business has failed. In such cases, creditors can apply to the cour ts to have the company placed into liquidation. The ATO, more than any other creditor uses this process to put insolvent companies into liquidation. This stops them incurring further debt and also stops the directors from using the company s tax losses to reduce future tax. Of course, this process requires a registered liquidator. Receivership Banks and other lenders often require a registered charge before they will lend money to a company. A charge over a company is like a mortgage over a house. It gives the lender security over the company s assets. What makes a charge different from a mortgage is that it usually applies to all of the company s assets. However, these assets change from day to day as the company buys stock, sells goods, obtains payment of invoices, etc. Such a charge is described as a floating charge, meaning that it floats above the company s assets and only attaches to them if the company defaults. When there is a default, the creditor needs to appoint a receiver to go into the compan y and take possession of whatever assets are then on hand, for the benefit of that creditor. By law, a receiver must be a registered liquidator. 10 If this system did not exist, businesses would be unable to raise loans on the security of assets such as stoc k. Accordingly, the receivership system is a vital part of corporate commerce. The policing role Companies can be used to commit fraud. For example, in some industries it is common to employ low -paid staff through companies, paying no superannuation, PAYG or other taxes. When these liabilities build up, the companies are liquidated and the staff are moved to another company to repeat the process. Part of the role of liquidators is to report these and other breaches of the Corporations Act to ASIC. This is a legal requirement under the Corporations Act for liquidators, 11 for receivers 12 and for administrators s 444A(2), Corporations Act 2001 (Cth) 9 s 588G, Corporations Act 2001 (Cth) 10 s 418, Corporations Act 2001 (Cth) 7

8 Only a small percentage of these offences are ever prosecuted. However, without the reporting role of liquidators, the number of prosecutions would probably be even smaller. Why liquidators need to be paid from creditors funds The need for liquidators to be paid The facts are simple. Our insolvency regime needs liquidators. Liquidators need to be paid. There is no system for paying liquidators other than from the funds of the companies, or from money able to be clawed -back from creditors, directors or other third parties. Cross subsidising small liquidations Most insolvent companies are small companies with little or no assets. The following table 14, published by ASIC, shows that over 60% of companies placed into liquidation have less than 5 full time employees. Only 5.4% are recorded as having more than 20 full time employees. Table 7: Initial external administrators reports Size of company as measured by number of full-time employees ( FTE ) (1 July June 2010) Less than 5 FTE 4, % Between 5 and 19 FTE 1, % Between 20 and 199 FTE % 200 or more FTE % Not known 1, % Total 7, % In many liquidations of these smaller companies, the only way the liquidator can be paid is by clawing back payments made to creditors in the period leading up to the liquidation. If they could not claim these payments back from the creditors and use them to pay their fees, they would often be unpaid. Being appointed as a liquidator of a company involves the liquidator spending at least several hours of work, even for a company with no assets. Under the present system, many liquidators will consent to being app ointed as liquidator of any company, sight unseen. They realise that in many cases, they will work for a number of hours and receive nothing. Their incentive is the hope of finding a company where they will be paid, often by clawing back payments previously made to creditors. 11 s 533, Corporations Act 2001 (Cth) 12 s 422, Corporations Act 2001 (Cth) 13 s 438D, Corporations Act 2001 (Cth) 14 ASIC, Insolvency statistics: External administrators reports 1 July June 2010 (2010) <http://afr.com/rw/ /afr/2011/01/05/photos/34da e0-ac09-3f37d953ddbc_asic%20insolvencies%20report%20wednesday.pdf> at 17 August

9 Why liquidators need to be paid highly When one looks at the amount charged by liquidators for individual liquidations, their fees seem very high. However, one should also consider the number of companies they liquidate, where they are paid nothing. Under the present system, the creditors of larger companies, in effect, subsidise the liquidation of companies with no assets where the liquidators are not paid. Comparison with bankr uptcy The liquidation system may be contrasted with bankruptcy, where a trustee is appointed to handle the bankrupt estate of an individual. Like liquidations, many bankrupt estates yield no money to pay the bankruptcy trustee. However, the bankruptcy system has a different solution. The Insolvency and Trustee Service Australia (ITSA) is a government body which supplies a bankruptcy trustee to any bankrupt estate. There are also private trustees for bankrupt estates. However, ITSA handles the majority of bankruptcies, where there is no money to pay fees. ITSA obtains a substantial part of its funds from a small percentage levy on the assets of bankrupt estates. Alternatives to the present remuneration system Since 2005, ASIC has administered a fund to pay liquidators for assetless administrations. However, the budget is very limited and the liquidator has to carry out substantial work before being eligible for any such payment. In July 2011, the Insolvency Practitioners Association of Australia, which represents around 85% of liquidators, made a submission to Treasury. 15 It suggested that funds to pay for assetless liquidations should be obtained from placing a levy on all new companies, as they are registered. This money would be used to pay liquidators of companies with no assets. They also put forward, but dismissed, the idea that ASIC should simply deregister those small insolvent companies, without any liquidation at all. In Hong Kong, there is a system for practitioners to bid for the work, quoting a fixed fee for the administration of insolvent companies. The present system for paying liquidators for administering assetless companies can at times be haphazard and unfair. It involves the liquidator agreeing to be appointed to any company, hoping that there will be some money that can be recovered, probably from payments to creditors. If so, those creditors, in effect, pay the liquidator s fees. If not, the liquidator is unpaid. 15 IPA, IPA Submissions (2011) <http://www.ipaa.com.au/default.asp?menuid=175&artid=364> at 17 August

10 Suggestions for reforms The following are some suggestions for reforms to the insolvency regime: 1. Employee entitlements The law providing that 100% of liquidators fees be paid before any payment of employees entitlements 16 should be changed. Because of the GEERS scheme, most of these employee entitlements are paid by the Australian government. The question arises, why should liquidat ors fees come before the rights of employees, at the expense of the taxpayer? 2. Preferences A creditor who was paid by a company before it went into liquidation should not have to give that payment back to the liquidator, unless at least the majority of t hat money will go to the creditors, rather than being taken for liquidators fees. 3. Insolvent trading If the directors allow a company to run up a debt when the company cannot pay it, they are personally liable for that debt. This is fair. However, by law 17 the liquidator has control over collecting that money from the directors. In practice, almost all of the money received goes to paying the liquidator s fees, unless the liquidator consents to or the court permits, recovery by the creditor. Those creditor s should have the right to claim directly from the directors, without the money going to the liquidator. 4. Incentives not to pay tax The many incentives for a company not to pay tax should be removed. The most blatant is the law 18 that directors may be personally liable for PAYG paid before the company was liquidated. It means that the directors of a struggling company, which pays that tax, will probably end up paying the tax personally, after the liquidator claims it back from the ATO as a preference. This s hould be repealed immediately. It is unreasonable to punish directors because their company paid tax. 5. Liquidators monopoly The law should be changed to allow insolvent companies to be liquidated by chartered accountants or lawyers, who can be appointed and disengaged by the directors. This will expose liquidation fees to ordinary market forces. 6. Assetless administration The existing assetless administration fund should be expanded to pay a reasonable fee to liquidators who are prepared to administer companies with no assets. 16 s 556, Corporations Act 2001 (Cth) 17 s 588M, Corporations Act (Cth) 18 s 588FGA, Corporations Act (Cth) 10

11 Conclusion It is the view of this author that the Senate enquiry was sidetracked after receiving multiple submissions from liquidators and their lobby group. The Senate committee concentrated almost entirely on a small number of liquidators who broke the law. However, that is not the only problem. The main issue is the vast bulk of liquidators who legally pay themselves millions of dollars out of the companies money money that would otherwise go to the employees and creditors, including the Australian taxpayer. The Senate committee s first recommendation was that the Australian Insolvency Practitioners Authority (AIPA) be established as part of the Insolvency and Trustee Service Australia (ITSA), to take over from ASIC. It then recommended a further enquiry. These recommendations appear to have been ignored. However, we do not need another acronym or another enquiry. We need serious changes to the law to enable the funds of insolvent companies to go to the appropriate parties. About the author Tim Somerville is an accredited specialist in business law and provides business and taxation advice to small and medium sized businesses. He is the founding partner of Somerville Legal, established in 1983, and was also the president of the North Metropolitan Law Society from 2005 to 2009, and has served on the Law Society Committee for specialist accreditation in business law. Tim Somerville is also the author of the Business Law module of LexisNexis Practical Guidance Since its establishment in 1983, Somerville Legal has rapidly grown to become North Sydney s largest law firm, with accredited specialists in Business Law and Family Law, accredited Estate Planning practitioners, litigation specialists and notaries. For more information, visit About LexisNexis Practical Guidance Designed to match the way you work, LexisNexis Practical Guidance is like having your own specialist legal practitioner on your desktop. Our expert team of legal practitioners and the LexisNexis team of legal editors have put together a range of essential resources to guide you through a range of specific practice areas, including business law, family law, employment law, property law, and a general counsel module. LexisNexis Practical Guidance provides you with access to guidance notes, primary law, precedents, forms, checklists and excerpts from authoritative LexisNexis commentary, so you can cut costs, save time and focus on profitable client work and developing new business. For more information about how LexisNexis Practical Guidance can help your practice, visit. The opinions expressed in this whitepaper ar e those of the author and not necessarily the opinions of LexisNexis Pacific. Media Contacts Rebecca Whalen PR, SEO & Social Media Manager LexisNexis Pacific (02) Jennifer Armstrong Chief Marketing Officer LexisNexis Pacific (02)

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