"Phoenix Fever"

Australia is currently in the grip of phoenix fever, as the Government launches a new wave of legislative attacks on the practice of business "rebirthing".

Despite this, few industry commentators expect that phoenix activity is going to disappear any time soon. In this article, I will survey the current regulatory and curial approaches dealing with phoenix activity.

The phenomenon

Phoenix activity has been defined as "the evasion of tax and other liabilities, such as employee entitlements, through the deliberate, systematic and sometimes cyclic liquidation of related corporate trading entities".^[1]

Phoenix activity, or "phoenixing", describes the phenomenon of, in its simplest form, transferring the assets of an indebted company into a new company under the control of the same director(s). The director(s) then either places the initial company into administration or liquidation (or leaves it to be wound up on the application of a creditor), in either case leaving it with no assets to meet creditor claims. The new company, meanwhile, continues the business of the original company, free of the original company's liabilities and with its assets out of the reach of the creditors of the original company.

This allows the business to continue in operation while the original company's creditors are left to claim against the now-assetless original company. Further, the liquidator of the original company is left without any resources to investigate or pursue claims against the director(s) of the original company.

Fraudulent phoenix arrangements are, however, often more sophisticated, involving a complex corporate structure, multiple entities holding different roles and segregation of asset-holding, liability-generating and labour hire entities. The Australian Taxation Office (ATO), frequently the largest victim of phoenix activity, has identified the structure of a typical fraudulent phoenix arrangement as follows:

• a closely held private group is set up, consisting of several entities one of which has the role of hiring the labour force for the business;
• the labour hire entity will usually have a single director who is not the ultimate "controller" of the group;
• the labour hire entity has few, if any, assets and little share capital;
• the labour hire entity fails to meet its liabilities and is placed into administration or liquidation by the ATO;
• a new labour hire entity is set up and the labour moved across to work under this new entity; and
• the process is repeated, with little disruption to the day-to-day operation of the overall business and the financial benefits from the unpaid liabilities are shared amongst the wider group.^[2]

Of the 10,200 companies that went into liquidation in 2009-2010, Dun & Bradstreet identified that 29 percent involved companies that had one or more directors previously involved with a wound-up entity – as compared with just 10 percent in 2004-05.^[3] The same research also revealed, more alarmingly, that:

• 170 directors in corporate Australia had been associated with more than 15 company collapses;
• the number of directors associated with two incidents of business failure increased from less than 8 percent of total business failures in 2004-05, to almost 20 percent in the 2009-2010 financial year; and
• by extension, directors involved in a business that entered external administration are 250 percent more likely to be involved in an insolvent wind-up at some stage in the ensuing 12 months.

The economic cost

Australia's Fair Work Ombudsman, Nicholas Wilson, recently released a research report into the economic impact of phoenix activity.^[4] That report estimated that the annual cost to the Australian economy of phoenix activity being between $1.78 and $3.19 billion, with:

• the cost to employees, in the form of unpaid wages and other entitlements, being between $191 million and $655 million;
• the cost to businesses, as a result of phoenix companies not paying debts, and goods and services paid for but not provided, being between $992 million and $1.93 billion; and
• the cost to government revenue, mainly as a result of unpaid tax – but also due to payments made to employees under the Government's scheme compensating employees of insolvent employers (General Employee Entitlements and Redundancy Scheme (GEERS)), being between $601 million and $610 million.

The report also acknowledges that there are a range of further impacts of phoenix activity which were unquantifiable, such as the impact on businesses' revenue of being undercut by phoenix companies, which gain an unfair competitive advantage by avoiding payment of debts.

The legal framework

Australia has no specific law against phoenix activity. That is because of the perceived impossibility of targeting fraudulent phoenix activity without also impeding genuine business recovery and restructuring.

As I will note below, that has not stopped Australian courts using a range of powers to counter phoenix activity and to punish its perpetrators. The exercise of such power is a relatively uncommon event, however. A recent decision shows that, although alive to the possibility of illegitimate phoenix activity, Australian courts are wary of punishing business-people who happen to be merely unfortunate or incompetent rather than devious, particularly where the Australian corporate regulators have declined to punish those individuals: Giudice v Bolwell [2012] VSC 280.

Mr and Mrs Giudice's company was wound up on the application of a creditor with a relatively small debt. When the liquidator assumed control of the company, he discovered that the Giudices had not been diligent in meeting their statutory obligations – there were a number of outstanding lodgements with the tax office and statutory superannuation (employee pension plan) instalments had not been paid.

After the liquidator's appointment, the Giudices got to work on organising their personal finances. This freed up enough money for them to pay off the company's creditors. First, however, they had to have the winding up order set aside and the company returned to their control.

Although the Giudices were now in a position to ensure that the company was solvent, the liquidator was initially concerned about returning the company to the control of directors who had failed to meet their statutory obligations.

The Court noted those concerns. However, it also observed that the corporate regulator had not considered the Giudices' failings to be serious enough to warrant banning them from acting as company directors. In that situation, there was nothing to prevent the Giudices from starting up a new company and running their business through it. In fact, Mr Giudice had incorporated a new entity from which to conduct business in the event his application to the Court was unsuccessful.

"Thus," said the Court, "the very act of commercial morality complained of by the liquidator could emerge again in the operation of a new company".

Faced with this dilemma, the Court embarked on a long inquiry into the relevance of commercial morality in the context of applications to terminate a winding up. It concluded that a failure to meet statutory reporting obligations can be indicative, but not conclusive, evidence of a lack of commercial morality.

It then turned to the situation of the Giudices:

"I do not discern dishonesty on the part of Mr and Mrs Giudice in their dealings. It would appear that the Giudices have now engaged professional advisors who will in future maintain the proper books and records for their business, whether conducted by Kitchen Dimensions or a new entity. They have learned a valuable but very expensive lesson. The cost to them in making this application has been very substantial. They might have been tempted to `let the company go' and start a new business. Instead, they have chosen to take the more difficult path of regularising the affairs of the company. It has been necessary to borrow about $785,000 to pay creditors.

Notwithstanding the assistance of recently appointed advisors, I remain concerned about the ability of the Giudices to manage the company into the future. If they continue to engage competent advisors they will have a much better chance of doing so; but there is always a risk that they will fail. If the [sic] do, their failure may prejudice future creditors. But in the absence of an order preventing Mr and Mrs Giudice from continuing to carry on business through a new entity, that risk will not be ameliorated by refusing this application [to terminate the winding up]."

This decision, of course, largely turns on its facts. However, it illustrates quite clearly the difficulty that legislators would face in trying to draft a law which specifically targeted phoenixing. It is for that reason that the Australian Parliament has chosen to outflank phoenix activity, rather than address it head-on.

Get the directors

Australian company directors have long been personally liable for unpaid tax; this is seen as a disincentive to phoenix activity, since the ATO is a creditor of almost every insolvent company. One recent legislative initiative has been to compound that disincentive by extending directorial liability in this area.

Legislation passed in June 2012 both extends the liability of directors who have not remitted withheld tax on employees' income to the ATO and introduces new directorial personal liability for unremitted employee superannuation contributions. The Tax Laws Amendment (2012 Measures No 2) Act 2012 was designed to achieve two objectives:

• reducing the incentive for directors to engage in phoenix activities by ensuring that phoenixing their business did not reduce their own personal liability; and
• ensuring that, even if a company becomes insolvent, there is some protection for employee pension contributions.

These amendments generated some controversy. Directors, for example, argued that the changes could catch directors who were not engaged in fraudulent phoenix activity. That claim was given some credibility by ATO estimates that there are around 6,000 phoenix companies in Australia at any one time – only 0.33% of the 1.8 million companies currently registered with the corporate regulator, ASIC.

Although the June 2012 amendments provided specific protection for employees, commentators have observed that the amendments did not directly address the issues faced by unpaid trade creditors, except insofar as any overall reduction in phoenix activities would also benefit them.

It was also pointed out that, in many phoenix operations, the persons whose names appear in the corporate records as directors are often mere frontmen for the businessman who effectively controls the company behind the scenes. This is not an insurmountable problem when it comes to recovering unremitted tax and pension payments: such eminences grises can be caught if a court finds that they are shadow directors. However, apart from the forensic difficulties in establishing that secondary liability, there is the added problem that many such operators may have arranged their affairs to ensure that they have little or no personal assets available to meet an adverse judgment.

Fast track to liquidation

Another legislative response to phoenixing is contained in the Corporations Amendment (Phoenixing and Other Measures) Act 2012.

This Act allows the corporate regulator (ASIC) to put a company into liquidation if it has been abandoned. The specific grounds are:

• the company has not paid its annual review (effectively, registration) fee within one year of the fee being due; or
• ASIC has reinstated the company's registration within the last six months and believes that winding up is in the public interest; or
• ASIC has reason to believe that the company is no longer carrying on business and there is no objection to the company being placed into liquidation.

The main purpose of facilitating this route to winding up (rather than just having the company administratively deregistered by ASIC) is to allow the company's employees to qualify for GEERS, the government scheme to assist with the unpaid entitlements of employees of failed companies.

It can be seen that this measure merely ameliorates some of the side-effects of phoenix activity, rather than attacking the phenomenon itself.

Arguably, it is also misdirected. Phoenix activity is a process of continuing a business under the aegis of a new company. To the extent that the successful continuation of the business requires a skilled workforce, employees are likely to be "looked after" by the operators of the business. Trade creditors are more likely to lose out, especially if the business owner can source goods and services from alternative suppliers.

What's in a name?

The last weapon in the Australian Government's armoury against phoenix activity is a proposal to restrict the use of companies that use a name similar to that of a failed company (the Corporations Amendment (Similar Names) Bill 2012).

This provision – clearly modelled on English law – is still in the planning/consultation stage. It would render a director of a company personally liable for its debts if the company had a similar name to a failed company of which he/she had also been a director. The liability would be for all debts incurred in the five years following the failed company's collapse.

As with the other legislative initiatives discussed above, this is not a panacea for phoenix activity. The threat of personal liability will hold little terror for business-people who have taken steps to ensure that they have very little in the way of attachable personal assets, and even less for those who have managed to control a company whilst not being formally appointed to the office of director – even assuming that their phoenix company is held by a court to have a "similar" name to its failed predecessor.

The "similar names" initiative is curious, particularly given the perceived failure of the English legislation on which it is modelled. As one commentator noted "if the objective of [the "similar name" provision in section 216 of the (English) Insolvency Act 1986] was designed to curb the potentially prejudicial effect of the phoenix syndrome, the provision must be viewed as an unmitigated failure".^[5]

Judicial response to the legislative lacunae

Despite the legislative shortcomings, where their jurisdiction has been invoked Australian Courts have, over the years, shown little toleration for phoenixing, as three major decisions show.

Just and equitable

The Guss family conducted their furniture business through a series of companies. There was a (30 year) history of running up tax debts in one company and, before the company could pay those debts, transferring the business to another company (and so on), leaving the debt-laden predecessor company to be wound up.

In 2001, the latest company in the chain (Casualife Furniture International) had run up tax debts. The ATO applied to have Casualife wound up while it was still a going concern: Deputy Commissioner of Taxation of the Commonwealth of Australia v Casualife Furniture International Pty Ltd [2004] VSC 157.

Despite its tax debts, Casualife was apparently trading profitably. Since the ATO couldn't apply for winding up on the grounds of insolvency, it applied for a winding up on the "just and equitable" ground. (In Australia, the "just and equitable" ground has generally tended to be used to resolve intractable disputes between shareholders of small companies.)

The ATO argued that it would be "just and equitable" to wind up the solvent Casualife because:

• the ATO lacked confidence in the conduct and management of the company and its furniture business;
• fairness required that the company be wound up; and
• it would be conducive to commercial morality and in the public interest to wind up the company:

(i) so that its affairs could be wound-up and brought under the control of a liquidator; and

(ii) so that further commercial immorality could be prevented.

A few weeks after the ATO began legal proceedings, Casualife paid its tax bill. It then claimed that it should not be wound up, because:

• the ATO was no longer a creditor;
• the company was solvent (and had a number of employees); and
• there was no reason to doubt that the company would meet its tax obligations in future.

The Court disagreed. It ordered that Casualife be wound up:

"The Deputy Commissioner's lack of confidence in the defendants' likely observance of their taxation obligations is well justified in the circumstances. For that reason and also because it would be fair to do so, it is appropriate to order winding up. If the defendant companies were not wound up they would continue operating in the public domain under the same Guss control who would, I find, continue to engage by these entities in the same type of impugned conduct. I am also of the view that it is in the public interest and conducive to commercial morality that the companies be wound up, both to prevent the perpetration of further commercial immorality and for the benefit of having the companies under the control of a liquidator."

Despite the ATO's success and the Court's strong disapproval of the Guss family's activities, Casualife appears to have been something of a false dawn. It did not give rise to a host of similar anti-phoenixing applications by the ATO.

In addition, there is no evidence that the decision served as a major deterrent to phoenixing. Hopes of a deterrent effect were greater in 2008, when the authorities adopted a different tactic: rather than targeting only the phoenix operators, they targeted those whose professional services were essential to a successful phoenixing operation.

Somerville's case

Mr Somerville was a solicitor. He advised directors of failing companies to establish a new company and transfer their business out of the failing company and into the new company. The new company paid for the business by issuing special shares to the old company. These shares carried special dividend rights, but no such dividends were ever declared or paid.

ASIC began proceedings against the directors of a number of such companies, for breach of their statutory duties to their old companies. The directors were found to have breached their statutory duties to act in good faith and for a proper purpose in the interests of the companies – those interests including, in the context of insolvent or near-insolvent entities, the interests of creditors. Windeyer AJ of the Supreme Court of New South Wales found that there was "no proper basis for the transactions other than to keep the benefit of the assets in the new company without the burden of the liabilities". ASIC also began proceedings against Mr Somerville on the grounds that he was a person "involved in the contraventions" by the directors.

Declarations of contravention were made against each of the directors and against Mr Somerville. The Court also banned Mr Somerville from managing corporations for six years. The significant part of the case was the Court's rejection of Mr Somerville's argument that he should not be punished simply for giving legal advice:

"That of course may be the position in a normal case, but that depends upon what advice was given. If advice is given the result of which brings about an action by directors in breach of the relevant sections of the Act, in other words, when advice is given by a solicitor to carry out an improper activity and the solicitor does all the work involved in carrying it out apart from signing documents, it seems to me that there can be no question as to liability."

As the Court recognised, this was a test case by ASIC, taken with the specific intention of discouraging professional advisers from providing advice to assist phoenix activity.

Not a phoenix

The last case is this brief survey did not actually involve a phoenix company, but it demonstrates the Australian courts' ongoing concerns about the role of professional advisers to companies which are in financial distress: Haulotte Australia Pty Ltd v All Area Rentals Pty Ltd (In Liq) [2012] FCA 615

Mr McLeod was a liquidator. Mr Slade was an accountant. In the past, Mr Slade had referred insolvent clients to Mr McLeod. On this occasion, Mr Slade invited Mr McLeod to become the voluntary administrator of All Area Rentals. Mr McLeod accepted the invitation. As is quite common, the voluntary administration segued into a full-blown winding up, and Mr McLeod became the company's liquidator.

Haulotte, one of the company's creditors, applied to have Mr McLeod removed as liquidator.

One of the reasons cited by Haulotte was that All Area's director had allegedly set up a new company with a similar name ("All Site") and was now operating from the same address with the same phone and fax numbers as All Area. Haulotte learned that All Area had issued a circular to its "valued customers" just 5 days prior to the appointment of the administrator noting the change of name to All Site and directing them to make future payments (and the Court inferred, presumably also payments in respect of past business), to All Site. The director had also allegedly transferred all the company's trade debtors – but only some of its creditors – to the new company.

Mr McLeod knew about the new company and the purported transfer of creditors. He did not know, until Haulotte's application to have him removed, about the alleged transfer of the debtors. In fact, when he had earlier asked the director and Mr Slade, they had told him that the old company did not have any trade debtors.

The Court described this situation as " rather troubling":

"the situation is one which calls for a vigorous and independent approach on the part of the liquidator of the [All Area], whoever that may be. I do not find that [Mr McLeod] shares any of the responsibility for the matters to which I have referred, but, when I come to the question whether it would be in the interests of the liquidation of [All Area] generally for him to remain as liquidator, those matters have given rise to obvious concerns."

In the Court's view, there were two major reasons why Mr McLeod was not the appropriate person to take that vigorous and independent approach: his relationship with Mr Slade and his lack of scepticism:

"[Mr McLeod] was appointed on the initiative of Mr Slade, [All Area's] accountant. While I have no reason to doubt that there is a completely professional relationship between these two men, nonetheless Mr Slade has been a source of work for [Mr McLeod]. I would have to say that, on the evidence as it presently appears, steps taken by, or with the endorsement or knowledge of, Mr Slade ... are likely to be subjects proper for investigation by the liquidator. In the circumstances, it would be preferable for those investigations to be undertaken by someone with no prior connection with Mr Slade, and having no expectation of obtaining work from him in the future. Relatedly, in the particular circumstances of the case as they have been revealed, there is an argument that the interests of the creditors would be best served by the appointment of a liquidator who had not been administrator during the period when the first defendant was in administration. It is true that, during that period, [Mr McLeod] lacked the powers of investigation that a liquidator would have, but he was nonetheless in charge of a company during a period in which there were enough signs of the transfer of the business of the first defendant to All Site reasonably to have required him to be sceptical of the response from [the director] that there were no debtors and of [the director's] failure to provide the [bookkeeping] file. No such scepticism was to be seen in his second report to creditors or, I would have to say, in his evidence to the court."

Conclusion

On a positive note, one issue Australia does not have – at least not in comparable terms – is the concern that a legitimate "pre-pack administration" regime can be a vehicle for fraudulent phoenix activity.^[6]

In the United Kingdom, pre-pack administrations (where a company's business and assets are sold on terms that were negotiated between the buyer and the administrator before the company formally entered administration) have given rise to complaint that they are particularly open to abuse by those engaged in phoenix activity. A pre-pack sale is often concluded rapidly by the administrator with limited disclosure or control available to creditors. The high incidence of sales to related parties exacerbated the concerns expressed and led to a review by the British Department for Business, Innovation and Skills. Ultimately, Minister Edward Davey determined not to introduce any new legislative controls on pre-pack administrations "[A]s much of the concern was related to small businesses" and because compliance by insolvency practitioners with the British Insolvency Service's professional standard Statement of Insolvency Practice 16 (Pre-packaged Sales in Administrations) already required administrators "to provide creditors with early post sale information on details of the sale and the justification for it."^[7]

The regulatory problem with phoenix activity is that it is difficult if not impossible to draft legislation that can target those who engage in it (such as the Guss family) without also punishing innocent but merely hapless failed business-people (such as Mr and Mrs Giudice).

This is clearly borne out by the Australian experience, which combines a series of very narrowly-targeted legislative attacks on the indicia of phoenix activity with appropriate judicial use of existing legislative sanctions which are not specifically "anti-phoenix". This might, with some degree of accuracy, be described as a war of attrition against phoenix activity, rather an ultimate deterrent.

This article was first published in the International Bar Association Insolvency & Restructuring International Journal, September 2012 Vol 6 No 2

^[1] Australian Government (Treasury) 2009, Action against Fraudulent Phoenix Activity: Proposals Paper, p1 ^{Back to article}

^[2] Australian Government (Treasury) 2009, Action against Fraudulent Phoenix Activity: Proposals Paper, p2 at 1.1.2. ^{Back to article}

^[3] Undertaken for Sydney Morning Herald Weekend Business by Dun & Bradstreet – see "A free rise from the ashes of others", Sydney Morning Herald, 11 December 2010 by Adele Ferguson. ^{Back to article}

^[4] Phoenix Activity: Sizing the problem and matching solutions, June 2012, Fair Work Ombudsman/Pricewaterhouse Coopers. ^{Back to article}

^[5] S Griffin "Extinguishing the Flames of the Phoenix Company" (2002) 55 Current Legal Problems 377 at 388  ^{Back to article}

^[6] "Pre-packs can inspire anger among creditors who lose money when failed companies are sold back to the existing management team, creating "phoenix firms". Insolvency Service figures show that 72pc of reported pre-pack sales last year were to related parties." by James Hurley, The Daily Telegraph (UK), 22 August 2011 ^{Back to article}