Dealing with the insolvency of government-funded bodies

By Brian O'Callaghan and Lyndal Buik.

Key Points:
Government should use protective mechanisms (such as taking security over the funds or ensuring the funds are held on trust) from the outset when establishing funding arrangements or drafting funding agreements.

In the current unstable economic climate, governments may increasingly encounter situations where an entity which the government has funded runs into financial difficulties and, possibly, becomes insolvent. More often than not, that entity will owe money to the government. The most common situation is that the entity has unspent government funds which it has a contractual obligation, under its funding arrangements, to return to the government, or residual equity in government-funded assets.

In such situations the government and its advisers may find themselves having to negotiate competing priorities. On the one hand, the Australian taxpayer’s interests are in the "protection" or recovery of the public funding and/or the continued provision of the facilities and services that the funding was intended to achieve. On the other hand, there is the effect of insolvency and external administration laws (focusing on the protection of the employees and creditors (particularly secured creditors) of the insolvent entity, and in the case of voluntary administration, on the "rescue" of the insolvent entity).

In the first part of this article we will look at challenges that the government faces in insolvency situations. In the second part we will look at some solutions: focusing on the initial drafting of government funding arrangements.

The challenges: What can the government do to recover funds/assets from an insolvent entity?

The general statutory priority afforded to Commonwealth debts in corporate insolvencies was abolished in 1979 (with the exception of certain taxation debts, which received priority until 1993). This move was widely approved and it is generally now agreed that, as a matter of public policy, the Government should obtain no special priority in an insolvency situation.

What this often means in practice, however, is that taxpayer funds (or taxpayer-funded assets) provided to an entity to achieve a particular policy objective end up being eaten up through the corporate administration or liquidation processes. Had the government been able to recover the funds, those funds could have been reapplied by the government for the furtherance of the initial policy objective. Similarly, the initial government policy objective might have been better achieved by the transfer of government-funded assets (for example, facilities committed for the delivery of community services or special-purpose medical or research equipment) to another entity, rather than by the sale and realisation of those assets in a liquidation, and the distribution of those assets to all eligible creditors.

Thus, the government is often legitimately concerned to quarantine government funds or government-funded assets in an insolvency situation. In practice, however, this can be quite difficult to achieve. This is particularly so where the funding arrangements have not been specifically designed to protect the government funds or funded assets in the event of an insolvency.

Once government funds have been transferred to an entity, those funds become part of the potential pool of assets belonging to the entity which are available to the entity’s liquidator or administrator in a winding up or other form of external administration. The government may have a contractual right to repayment of those funds. However, this will give the government only the same rights as any ordinary unsecured creditor. In such cases the only way for government to receive any payment in respect of debts owed to it would be to submit a proof of those debts to the liquidator or administrator. Whether or not the government and other unsecured creditors receive a distribution in respect of their debts, and the amount of that distribution, will then depend on the assets available for distribution and the amounts that are required to first be paid out to priority creditors (eg. secured creditors such as banks and finance companies and employees).

Submitting a proof of debt is, however, often legally and practically the only option for the government at this stage. For one thing, it is generally unlikely that the funds or assets would be easily accessible or available for repayment to the government. More importantly, however, a direction by the government to repay funds or transfer assets to another entity, if complied with by the directors of the insolvent entity, has the potential to result in liability for insolvent trading for the entity’s directors, or even for the government itself on a de facto basis. There is also a risk that such repayment or transfer could later be set aside by the liquidator as an insolvent transaction.

So, what can the government do at this point in respect of a debt owed to it by the externally administered or insolvent entity? At that stage, the options are very limited. However the following actions should be taken to ensure the government has the best chance possible of protecting its position:

• Terminate the funding agreement as soon as the department/agency becomes aware of the insolvency and do not provide further funds. (In most standard funding agreements the termination for default provisions will be triggered by an insolvency event.) Providing further funds to assist the organisation stave off insolvency can often merely compound the problems of both the entity and the government.
• Ensure that the relevant departmental/agency personnel know who has been appointed as the entity’s liquidator or administrator and maintain regular contact with them. This is particularly important in the case of a voluntary administration where the outcomes for the entity can be determined by a Deed of Company Arrangement, administered by the administrator and agreed to by the creditors.
• Ensure proofs of debt are completed and lodged as early as possible in the proceedings.
• Ensure, at an early stage, that the department/agency informs the liquidator or administrator of all government-funded or owned assets which are in possession of the entity.
• Ensure the department/agency is represented at all creditors’ meetings. Again, particularly in a voluntary administration, the creditors control proceedings and voting on important matters occurs at creditors’ meetings. The government may be the major creditor and in such circumstances would be able to influence the structure and purpose of the Deed of Company Arrangement in a voluntary administration.
• Seek legal advice as required.

Some solutions

As illustrated above, at the point in time at which an entity becomes insolvent, there is not a great deal the government can do to recover funds from that entity.

The key is to have taken appropriate measures from the outset, that is, when setting up the structure of the funding arrangements. In the first place, it is desirable, if not necessary, in order to protect the funding and also to protect the government’s ability to ensure ongoing provision of the funding purposes, to anticipate the risks involved, and properly plan for mechanisms within the funding arrangements to mitigate these potential risks. This involves a proper analysis or assessment of the funding purposes and the financial viability, corporate and ownership structure of the entity being funded. It also includes, where the government
is funding the acquisition of assets or the construction of facilities to provide community services, a proper understanding of the ownership of the land and/or buildings on which the facility is to be constructed or the asset installed.

The following mechanisms are worth considering when initially drafting or establishing government funding arrangements in order to ensure that government funds or funded assets can be recovered and the purposes for which the funding was provided achieved:

• Staggering the payment of funding instalments:
  This mitigates the risk that, in the event that an entity does become insolvent, it is holding large amounts of unspent government funds (which could otherwise become available to fund another party to undertake the funded purposes);
• Robust reporting and notification provisions: Forewarned is forearmed. The earlier the government knows about any solvency issues a funded entity may be suffering, the better the chance of the government protecting its position. The entity should be required to provide regular financial reports to the government, and notify the government immediately if there is any hint of insolvency;
• Security: Secured creditors will receive priority in an insolvency over unsecured creditors. There are a number of options available to the government in terms of taking security in order to protect the funds or assets acquired with the funds. The government could for example take a charge (floating or fixed, or both) over the assets of the entity, to the value of the funds provided. In the case of real property or facilities constructed with government funds, the government could consider registering a real property security to protect its interests;
• Guarantee: A third party guarantor of substantial financial standing could be required to guarantee to pay the government any funds owing to it by an entity if the entity were to enter into a form of external administration. However, a financial facility of this type will cost money - the government will need to consider, on a case-by-case basis, whether such additional cost is justifiable in value-for-money terms as a risk management measure, and if so how it will be met;
• Trust: Creating a trust over the government funds means that the beneficial ownership of the funds remains with the government (however, this approach may create issues with respect to the public money provisions under the Financial Management and Accountability Act 1997, which can be problematic for both the funding agency and the funded entity); and
• Retention of ownership: Finally, the most obvious way to protect an asset from any liquidation procedure is to provide that the government retains ownership or title to that asset or to a facility that has been acquired with government funds. The government could then lease or licence the asset or facility to the entity to undertake the provision of the funded services with that asset or from those facilities. If the entity becomes insolvent, then the government may make available those assets or facilities to another provider to continue the funding purposes. This can be an option in some circumstances, but, of course, may not be practicable or desirable in many other circumstances.

For further information, please contact Brian O'Callaghan and Lyndal Buik.