How do you strike the correct balance when looking at the interests of creditors and debtors in insolvent or potentially insolvent scenarios?
It’s not an easy question to answer. It’s an age-old problem. A fact of commercial life for as long as debtor/creditor business relationships have existed. However, one would expect that it’s important to keep trying. Trial, error and some cross-jurisdictional collaboration.
COVID-19 has accelerated insolvency reforms already in existence in the political agenda of many countries, and it has encouraged other jurisdictions to reassess their insolvency and restructuring systems.
In Australia, there were already widespread concerns about our insolvency and restructuring frameworks even before the pandemic (see ASBFEO’s ‘Insolvency Practices Inquiry’). So, what has been done or is being done to improve SME restructuring in Australia?
What is the real Target? What is an SME?
Micro, small, and medium-sized enterprises (‘MSMEs’ or more often referred to as simply ‘SMEs’) – are recognised as being important economic contributors internationally (see the United Nations General Assembly Micro, Small and Medium-sized Enterprises Day). In Australia, there is no agreed or uniform legislative definition of an SME. Legislation does, however, provide for differential treatment or special protections for certain businesses defined as ‘small businesses’ – see the Financial Services for SMEs Paper for a summary.
The ABS definition of a small business is one that employs less than 20 employees. A medium-sized business employs between 20 and 199 employees – which equates to medium businesses representing only 2% of all businesses operating in Australia according to the ABS.
In response the ASBFEO Insolvency Enquiry, ARITA made the valid point “the vast majority of external administrations in Australia are small businesses and that, therefore, concerns about how the insolvency regime addresses small business are, in fact, concerns about almost the entire operation of the regime”.
So, the real target is (or rather, remains) the micro and small businesses (often family operated and perhaps a majority having either just a few or no employees at all). There has been much commentary on growing medium-sized businesses, but in Australia there is less focus on helping small businesses grow to become medium-sized enterprises. The AICD come close from a governance perspective – with discussions tackling family business transitions in growth (see ‘entrapment’ by Andrew Mattner and the family governance growth transition example).
Churchill and Lewis provide an excellent paper in the five stages of small business growth (albeit its first date of publish was 1983). With robotics, automation and accelerating technologies like digital marketing and e-commerce, there should be a greater focus on small business viability and sustainable growth. When the situation is aggravated by a pandemic, the need for an effective SME restructuring and insolvency system is intensified considerably.
One size doesn’t fit all…
It is now generally accepted that Australia’s ‘one size fits all‘ restructuring tool was inadequate. Voluntary administration under pt5.3A has had questionable success rates for SMEs (for both creditors and debtors – the process was too costly, bureaucratic etc etc).
For a deeper dive into Australia’s corporate rescue regime, see the thesis by Jason Harris ‘Promoting an optimal corporate rescue culture in Australia: The role and efficacy of the voluntary administration regime.’
Success of voluntary administrations are also varied, subjective and often controversial (the eye of the beholder…). Some key success levels are highlighted well by Ben Sewell’s article here.
‘SME’ Restructuring = ‘Small Business’ Restructuring
COVID-19 led to many temporary adjustments of insolvency laws around the world for SMEs. More importantly though, it has accelerated these insolvency trends and encouraged many countries to reassess the appropriateness of their insolvency and restructuring frameworks as regards SMEs.
It is essential that the value in small businesses is retained by enabling an effective system for recycling, reinvigoration, and reinvention. Effective SME restructuring and succession planning are the foundations for economic recovery and growth.
Small Business – don’t forget the sole trader
The structural and legislative divide in Australia as regards personal and corporate insolvency continues to be raising issues. Principles seem to be tackled at either the personal or corporate insolvency level but not concomitantly. For example, the ASBFEO Insolvency Enquiry appeared to omit the sole trader – a ‘small business’ that falls within the personal insolvency category in Australia.
In the USA, the term bankruptcy extends to both personal and corporate insolvency (the Bankruptcy Code 1978). In the UK, personal and corporate insolvency is largely dealt with in the one piece of legislation (the Insolvency Act 1986). Australia’s Bankruptcy Act 1966 and the Corporations Act 2001 were formed at different times, have different histories, and different purposes.
Michael Murray makes a powerful point in ‘SME Insolvency an Alternative Approach’, stating:
“Competency is not determinative. The sole trader may have had a tourism business on which COVID-19 imposed unavoidable financial consequences; on the other hand, the director’s business might have been an in-demand medical supplier but through the director’s ineptness the business failed. One is blacklisted for 3 years, the other for none.”
Debtor in Possession vs Creditor in Possession
Australia has traditionally had what is called a ‘creditor-in-possession’ style insolvency model. Insolvency regimes take control away from the director/owners and give that control to the creditors (via a registered liquidator). Australia has origins from old English common law – which was extremely uncompromising and harsh in its approach towards those unable to pay debts on time.
Conversely, ‘debtor-in-possession’ leaves that control with the owners/management. Chapter 11 bankruptcy in the USA is a well-known debtor-in-possession model but it’s not the only jurisdiction to have adopted this approach.
For the small business owner, debtor in possession is attractive for a wide range of reasons, for instance the process can be quicker, more secretive and less expensive. They are best placed to manage the operational aspect of their business due to familiarity. On the other hand, from an apprehensive creditor’s perspective, a variety of concerns arise primarily due to the lack of control and there being less transparency.
Notwithstanding criticisms and concerns, debtor in possession style approaches repeatedly receive support and are increasingly being recognised as a valid business rescue methodology across jurisdictions (see the 2021 Paper by the World Bank). Insolvency laws around the world are evolving to incorporate more forgiving debt relief and restructure arrangements.
What moves have been made in Australia?
Let’s Do Nothing
The Government’s AFSA kindly provides a personal insolvency service to those individuals unable to pay their debts in a timely fashion. A Government agency liquidator, to handle assetless MSME corporate entities, is yet to be established (despite there having been talks).
Not much is said about ASIC’s default deregistration process for insolvent companies (point made by Michael Murray in response to the ASBFEO Insolvency Enquiry) and if neither the debtor nor the creditors take action, lack the funds or interest for liquidation – the company will remain insolvent but will be deregistered by default. Murray states that it “appears to be the government position”.
Murray and Harris are working on a project “Rethinking Insolvency Law”. This includes the involvement of a Government agency (official receiver) which, amongst other things, will “deal with the more than 100 thousand companies that are de-registered every year.”
2017 Safe Harbour
As part of the Government’s National Innovation and Science Agenda, the 2017 Safe Harbour under section 588GA of the CA was intended to prevent the premature cessation of companies. The overarching aim of the safe harbour is to encourage directors to seek advice early on how to restructure and save financially distressed but viable companies. It affords protection from personal liability for the directors of insolvent trading companies. This is provided the process is followed and it is reasonably believed that ongoing trading will result in a better outcome for the company.
The Treasury Laws Amendment (Combating Illegal Phoenixing) Bill 2019, which became effective February 2020, introduced the new creditor defeating disposition. Interestingly, the safe harbour process under section 588GA, is a defence to such property dispositions. This would appear to be relevant when considering academic opinions about abuse of the safe harbour process (Helen Anderson, Shelter from the Storm).
The belated two-year safe harbour review has commenced. The insolvency safe harbour is not published or made public – so the review should be expected to be more qualitative that quantitative.
Rise of the Prepack Pre-Positioned Sale?
Australia has been slow to adjust restructuring and insolvency frameworks when compared to other jurisdictions. Australia dislikes the controversy of the UK style prepack and this continues to be avoided. However, this is increasingly being considered across multiple jurisdictions (see Rise of Pre-pack as a Restructuring Tool – Global and Regional Perspectives).
The prepack fear appears to stem mainly from what the insolvency profession pejoratively terms ‘pre-insolvency advisers’. Michael Murray states that ‘pre-insolvency advice’ is hard to pin down:
“It can be encompassed within debt management; indeed, entering bankruptcy or liquidation is a valid way of managing unpaid debt. Advice to directors during the “safe harbour” period under s 588GA Corporations Act is an aspect of debt management.”
The main concern with pre-insolvency advice is where advice to debtors is to transfer or hide cash and assets to prevent them being taken by a trustee or liquidator, or the creditors (which is criminal conduct). Initially flagged by Michael Murray in June 2019, a senate committee recommended AFCA take a role in relation to the regulation of debt advisers and this could include debt management advice provided by pre-insolvency advisors (AFCA is the Australian Financial Complaints Authority).
Indeed, on 25 September 2020 the Government announced a package of reforms to Australia’s consumer credit laws. In May 2021, ASIC released an information sheet that from 1 July 2021, subject to transitional arrangements, providers of debt management services must hold a credit licence with an authorisation that covers debt management services.
ASIC has published a list of persons/entities that applied to ASIC for a credit licence or variation seeking the ‘debt management services’ authorisation by 30 June 2021 and were members of AFCA on that date (30 June 2021). So pre-insolvency advisers may now fall under the regulation of ASIC and require dispute resolution through AFCA membership.
Small Business Restructuring under Part 5.3B
The new small business restructuring process (SBRP) under Part 5.3B of the CA came into effect on 1 January 2021 with the aim of streamlining insolvency law and its processes to ‘save’ viable small businesses.
It was touted by the Treasurer as ‘a single, simpler, faster, more cost-effective insolvency process for small business’ and ‘a move to a more flexible “Debtor in Possession” model.
The following eligibility requirements are relevant for the business:
- must be incorporated under the Corporations Act;
- must have total liabilities do not exceed $1 million (excluding employee entitlements); and
- must be insolvent, or likely to become insolvent at some future time.
Uptake of the regime has been poor (when compared to pt 5.3A’s voluntary administration anyway). Academics’ critiques (Jason Harris and Christopher Symes) speak volumes (see The chimera of restructuring reform: An opportunity missed for MSMEs in pt 5.3B).
As stated by Harris and Symes “…the new procedure is not sufficiently simple or streamlined as suggested by the explanatory material and this means that it will be costly for companies, risky for practitioners and potentially unrewarding for creditors to be involved.”
“Costly” and “Risky for Practitioners”?
Harris and Symes also argue that pt 5.3B has “questionable compensation for registered liquidators to act as restructuring practitioners.”
The ‘small business restructuring practitioner’ must be an ASIC registered liquidator. Although since 1 January 2021, an application can be made by an appropriately experienced accountant – to act purely as a ‘small business restructuring practitioner’ (the SBRP is like a new subclass of registered liquidator – restricted to accepting restructuring appointments only). Unfortunately, the ASIC committees have only succeeded in appointing just one small business restructuring practitioner specialist since 1 January (as at September 2021). This is suspected as being a major contributing factor to the fact that the pt 5.3B regime take up has been so dismally low.
There are strong similarities with the England and Wales ‘Company Voluntary Arrangement’ (known as a ‘CVA’ – where the company qualifies as a ‘small business’ for a 28 day moratorium). The uptake wasn’t exactly huge here either (falling in the shadow of administration prepack booming at that point). Interestingly, however, the majority of the appointments that were undertaken were by a few insolvency firms that specialised in handling these CVAs in volume.
Put bluntly, existing registered liquidators have little incentive to take these new pt 5.3B restructuring appointments in Australia. The risks seem to outweigh the benefit at present and the process isn’t further enough departed from pt 5.3A to enable the cost reduction.
What the process needs (to be adequately tested) is more specialists – liquidators restricted to taking on the role as small business restructuring practitioner (or existing registered liquidators choosing to be pt5.3B specialists by setting up the right systems and processes). A different skillet may be required for this. A liquidator may need to re-arrange their organisational structure.
General accounting firms may be encouraged to have at least one qualified insolvency specialist capable of taking on the SBRP role. This may help with earlier referrals of distressed clients to registered liquidators where alternate external administrations are required.
Like software rushed to market, there are bugs and kinks with pt 5.3B. The barriers to entry need lowering and the process needs road testing.
Where is the Business Viability Review??
First raised by the ASBFEO and subsequently argued by Jason Harris ‘Is there a doctor in the house?’, the ABRT strongly supports the small business viability review.
Additionally, the key to getting the new pt 5.3B small business restructuring regime off the ground may all be about getting the planning right beforehand.
An outcome of the business viability review process is that the director is educated on formal and informal options, insolvent trading & safe harbour, voidable transactions, PPSR and security matters, landlord/lease issues, illegal phoenixing, operational roadblocks or bottlenecks, personal exposure (etc, etc).
At this point the advisor will have a reasonably strong understanding of the financial position, the issues with the various creditors and the likely hazards and hurdles ahead.
With sufficient planning and preparatory work, the advisor is suitably placed to assist the director in lining up the matter for a small business restructuring (for example, this might be following an attempt at an informal creditor workout). The small business restructuring process may yet prove to have some use – even if this is used as a negotiation tool, the last resort or just a safety net.
This is not new. This same approach has been used to make pt5.3A’s voluntary administration more accessible and successful (articulated well by Ben Sewell’s article).
Ben Sewell participated in the latest study and thesis by Jason Harris – stating back in June 2019 that “…Voluntary Administration should be treated as a last resort for an insolvent company“.
Is Progress Being Made?
The question first raised at the start of this article was:
How do you strike the correct balance when looking at the interests of creditors and debtors in insolvent or potentially insolvent scenarios?
With great difficulty. However, Australia certainly needs more that deregistration, the insolvency safe harbour, pts 5.3A and 5.3B as restructuring tools to deal with contemporary SME issues. As has been repeatedly pointed out, many MSMEs are simply ‘too poor to go broke’ and this is an issue where we have a privatised corporate insolvency system.
The language being used, however, is a good sign that change is underway. Or is it?
The test will be Australia’s ability to amalgamate personal and corporate insolvency legislation and practices, refine its SME restructuring processes and take a broader part in international discussions about MSME insolvency options.