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Insolvency laws should encourage rehabilitation

Readers of our Client Update will likely be familiar with the press articles written over the past few years concerning enquiries into the conduct of certain liquidators, the effectiveness of the Australian insolvency regime and most recently, the parliamentary enquiry into the impairment of customer loans.

These enquiries appear to conclude that current insolvency processes and practices are not as conducive to rehabilitating companies as they could and therefore legislation amendments are required.

Our firm does not necessarily wholly support this position, particularly as it relates to the traditional SME business failure experienced in our state. That said, we do accept that entering into a formal insolvency appointment within the current legal framework inevitably leads to a loss of economic value and in this way, inhibits the successful restructuring of companies in distress.

In our experience, successful company restructuring is best achieved outside of the current formal insolvency processes. For this to occur directors and advisers of companies are required to engage in the restructuring process earlier. An early involvement helps problems to be diagnosed and a clear and dispassionate assessment of outcomes to be discussed, which can lead to a restructuring that the directors themselves can control. Where the directors have been honest in their business, the process can be very effective in allowing them to get back to business quickly.

Given the current insolvency regime, if the directors consider their financial position from the view that the company is insolvent, or likely to become insolvent, only the voluntary administration procedure can be used as the restructuring tool.

The outcome we draw from this is that there can be effective legislation changes to help reduce the loss of economic value that occurs in a formal restructuring of a company, but those changes are quite some time from being drafted and enacted. In the interim, we continue to encourage directors of companies to view insolvency and restructuring professionals not as gravediggers for the terminally ill company, but as advisers to underperforming businesses that can be turned around.

Perils of an overdrawn director’s loan account and set-off in company liquidation

We continue to see company finances being used as if they were the personal finances of a director, whereby company funds are withdrawn when the need arises, rather than when profits are recognised.

When a company is being wound up in insolvency and the funds withdrawn are greater than those contributed, a liquidator is empowered to cause the overdrawn loan account (which is the property of the company) to be collected and applied in discharge of its liabilities. An inevitable outcome when a recovery action is pursued by the liquidator is the loss of the director’s personal wealth and potentially the personal insolvency of the director.

Whilst an overdrawn loan account is not new in small business, we are seeing some novel defences from accountants in response to demands for the repayment of overdrawn loan accounts and thought an example of a successful defence may be useful.

The Defence

Upon the establishment of credit accounts with a company’s key suppliers, the company director granted personal guarantees in favour of the supplier to secure the company’s indebtedness. To support the guarantees the director also agreed to charge all his estate and interest in real property in favour of the suppliers. Needless to say, following the collapse of the director’s company, the suppliers pursued the director’s personal guarantees along with his real property, and at the same time, the liquidator pursued the recovery of an overdrawn loan account.

Section 553C(1) of the Corporations Act provides that if a creditor and a company in liquidation had mutual dealings, the creditor is entitled to set-off any sum the creditor owes to the company against the debt which it is owed by the company. Importantly, the Act ensures that set-off is not available where the party seeking the benefit, at the time of dealing with the company, had notice of the company’s insolvency (Section 553C(2)).

In our view, the director is entitled to set-off against any liability he had to the company by way of loan account the amount he is entitled to claim from the company in respect of payments made as guarantor. As noted above, Section 553C does not apply if, at the time of giving or receiving credit from the company, the person had notice of the fact that the company was insolvent.

In the context of a guarantee given by the director, the time at which the director gave credit to the company was when the guarantee was executed, not when the guarantee was enforced. This is on the assumption that there is no reason to expect that the director had notice of the company’s insolvency at the time the guarantee was executed.

In these circumstances, Section 553C(2) will not apply; instead, the set-off effected by Section 553C(1) is applicable. Section 553C(1) has automatic operation and will defeat the claim of the liquidator for the overdrawn loan account, but only to the extent of payments made under the guarantees.

Restructuring for SME businesses

Restructuring often involves large companies that reschedule syndicated loan facilities, implement debt for equity swaps, divest divisions to pay debts or replace the board/CEO/chairman in order to facilitate a new strategic direction. During a large company restructuring, there are many levers that can be pulled that simply are not available in a small company restructuring.

So, what does an SME restructuring look like? At its core, restructuring needs to enable a company to address poor performance or underperformance that has manifested itself into poor cash flow and creditor overhang. Changing performance of the company takes time to investigate, implement, and even longer to manifest into improved cash flow, so restructuring (outside of insolvency processes involving voluntary administrations and deeds of company arrangement) must start well before the problems become blatantly obvious.

We understand that for many SME directors and shareholders one of the greatest challenges is accepting the need to initiate a restructuring process, given concerns about cost, uncertainty of outcomes and fear of losing control. However, these uncertainties can be addressed early in the process so that the directors/shareholders can be involved in the process and not stood aside.

The starting point for implementing a successful restructuring is to initiate processes early. This can be achieved when businesses set themselves meaningful budgets and cash flow goals which are then used by management and compared to actual performance on a monthly basis. It is through this process that underperformance is first detected and the need for corrective action can be initiated.

The key to accurate budgeting is to ensure budgets factor in HP balloon payments, other loan payments and sensitivities with respect to changes in critical drivers of profitability. Sensitivities should consider the increasing costs of imports (particularly with the falling Australian dollar) and factor in potential interest rate increases in the medium term.

As we discussed in previous articles, the key work during a restructuring is to create the turnaround plan and begin the time-consuming processes to identify strategic strengths, weaknesses, opportunities and threats, reduce overheads, improve profit margins and re-schedule debt. The core of a successful restructuring is to find ways to re-balance cash flow so that debts can be paid as they fall due.

The key message from this article is that SME restructuring (outside of formal insolvency processes) is hard, it takes time and there are fewer levers to pull than for large companies. We understand director reluctance to initiate the process; however, we encourage directors not to be lax and to be vigilant for signs of underperformance creeping in. If left unchecked, underperformance could result in urgent restructuring, often only with the benefit of the more invasive and costly voluntary administration/deed of company arrangement processes.

Terminating a DOCA on the basis of a material omission

You may be excused for thinking that once a Deed of Company Arrangement (“DOCA”) has been voted and agreed to by creditors that it will be binding into the future.

In the recent matter of Recycling Holdings Pty Ltd [2015] NSWSC 1016, the Supreme Court of New South Wales was called upon to make orders to terminate the DOCA on the grounds that the administrators’ report contained misstatements and that the DOCA was not consistent with the administrators’ report.

In this matter, Recycling Holdings Pty Ltd (the Company) was in liquidation and the director’s suggestion of a voluntary administration was initiated. At the time of the liquidation, the Company was pursuing a claim against three of its creditors who also had brought a cross-claim against the Company (amongst others) in respect to unpaid monies.

At the second creditors meeting, a resolution was carried that the Company execute a DOCA. The effect of the DOCA was to:

• return control of the Company to the director; and
• establish a fund for distribution pro rata to creditors that would comprise both the proceeds of the litigation and the sale of the Company’s plant and equipment.

If everything went to plan, the creditors were to receive a dividend of 100 cents in the dollar. If the anticipated proceeds of the litigation materially changed and the creditors were to receive less than 100 cents in the dollar, the creditors could terminate the DOCA.

Later, the creditors who were the defendants to the litigation commenced proceedings for orders to:

• have the DOCA terminated or declared void on the basis of certain misstatements and omissions;
• have the DOCA terminated on the basis of non-disclosure of voidable transactions; or
• have the administrators removed on the basis of actual or perceived bias.

The orders were sought on the basis that there were material omissions from, or misstatements in, the information provided to creditors in the administrators’ report and at the second creditors meeting.

The defendants argued that the administrators’ report omitted a number of vital pieces of information about the litigation, its merits and the existence of a potential conflict of interest. The defendants also contended that a potential unfair preference or uncommercial transaction had not been disclosed in the administrators’ report to creditors.

The court found that there was a material omission of information in the administrators’ report and the administrators had failed to investigate or disclose information concerning the potential unfair preference or uncommercial transaction claim which was also material.

The court, however, declined to make orders terminating the DOCA on the grounds of the material omissions having regard to:

• the importance of the information;
• whether the creditors were actually misled; and
• the present attitude of the creditors once disclosure is made.

However, the court did make orders to vary the DOCA instruments to make it consistent with the administrators’ report.

Finally, the defendants asked the court to remove the deed administrators on the basis that there had been pre-appointment discussions concerning the potential terms of the DOCA before the Company was in administration. The court also dismissed that argument and it found that pre-appointment discussions concerning preliminary views regarding the DOCA were not sufficient to impact upon independence and indicate bias.

This decision is a reminder that while material omissions in a Section 439A report should be avoided, they will not always be fatal. Further, a reasonable perception of bias will not necessarily arise in circumstances where an administrator has conveyed their preliminary views on a DOCA to the DOCA’s proponent prior to the administrator’s appointment.

New address for Heard Phillips

We are pleased to announce that in December we will be relocating our practice from level 1, 50 Pirie Street to level 12, 50 Pirie Street. Our new location on the top floor of the building provides our firm with further room to grow and we look forward to welcoming you to our new offices when you are next in town.