The Federal Government has released a consultation paper outlining proposed reforms to combat illegal phoenix activity. We welcome the release of the consultation paper as the issue of illegal phoenix activity, while discussed over the years, continues to be an ongoing issue. The consultation paper covers issues relating to corporate governance, insolvency and tax laws. This article focuses on insolvency law.
The proposed changes will, to a varying extent, affect insolvency practitioners, restructuring advisers, company directors and creditors. Submissions relating to the consultation paper are due by 27 October 2017.
What is illegal phoenix activity?
There is no legal or statutory definition of phoenix activity. That said, phoenix activity is a term that is often used in the context of a transfer of assets from one company to another to deliberately avoid paying creditors in circumstances where there is a link between the two companies. Commonly, the new company will have a similar name, management and ownership to the company that has been wound up.
There are two main types of illegal phoenix activity and these have become a focus for regulators.
- Pre-insolvency advisers may approach directors of a failing company and suggest phoenix activities as a way to save the business. For example, pre-insolvency advisers might suggest asset sales or restructures that will defeat creditors' interests. The company is left as an empty shell with no assets to ultimately be liquidated.
- In some more sophisticated cases, companies adopt phoenix activity as a business model from the outset. The directors of such companies never intend to pay trade creditors and other liabilities and, from the beginning, intend for the company's assets to eventually be transferred to another company. This gives an unfair commercial advantage to those that engage in such behaviour.
What is being proposed?
The consultation paper proposes a number of reforms to address and combat illegal phoenix activity. Some proposed reforms are light-touch, such as the introduction of a "phoenix hotline", while others are more significant, such as establishing a system for identifying entities at risk of engaging in phoenix activity and changes to the Corporations Act to deal with phoenix activity.
Identifying phoenix behaviour
The Federal Government has recognised the need for a mechanism to identify and target high risk individuals and entities, in particular those who may have adopted phoenixing as a business model. The inclusion of a statutory definition of illegal phoenixing has been considered, however the general consensus is that it is too challenging to strike a balance between a broad definition that may capture legitimate business turnaround and restructuring, and a narrow definition which may not capture more calculated and egregious behaviour.
Rather than attempting to include a statutory definition of illegal phoenixing, the consultation paper outlines a two-step process for identifying entities that are potentially engaging in phoenix operations by:
- designation as a Higher Risk Entity (HRE) which would be an objective test where entities are automatically "designated" once certain thresholds are met (eg. where an individual has previously been disqualified from managing a corporation or has committed a "phoenix offence"); and
- declaration as a High Risk Phoenix Operator (HRPO). The Commissioner of Taxation would have the power to make such a declaration and apply regulatory measures accordingly.
The consultation paper acknowledges that there is a risk that the first step may capture individuals or entities that were involved in a legitimate business failure. To address this, it is proposed that designation as a HRE be a prerequisite to being declared a HRPO. The ramifications of being declared as a HPRO are not settled, however one option that has been put forward is the introduction of a "cab rank system" for the appointment of a registered liquidator to that company.
In our view, this two-step process is sensible but will not be seamless. The second step will require careful deliberation by the Commissioner of Taxation and its implementation will need to be managed by having appropriately qualified and experienced people involved in the decision-making process.
Currently, there is no specific offence for illegal phoenix activity. Illegal phoenix activity is, however, generally captured by civil or criminal breaches of directors' statutory duties.
The consultation paper proposes amendments to the Corporations Act to specifically prohibit the transfer of property from one company to another if the main purpose of the transfer is to avoid paying creditors.
It has also been proposed that existing Corporations Act provisions be designated as phoenix offences. As noted above, this will lead to designation as a HRE. For example, a failure to keep correct records that would enable true and fair statements to be prepared may be designated as a phoenix offence (section 286(1)).
Cab rank system for appointment of liquidators
A registered liquidator may be appointed as an external administrator of a company as a:
- voluntary administrator;
- deed administrator of a deed of company arrangement;
- member or court appointed liquidator; or
- provisional liquidator.
Many of these appointments are initiated by the company directors and engaged by way of referral by a pre-insolvency adviser. Often, illegal phoenix activity is orchestrated where unscrupulous pre-insolvency advisers create relationships with registered liquidators who, together, are willing to prioritise the interests of their client over those of the company's creditors.
A cab rank system has been recommended where a registered liquidator would be chosen on a “next-cab-off-the-rank” basis in certain circumstances to minimise the risk that advisers, liquidators and directors collude to avoid payments being made to creditors. This would mean that generally, liquidators would be obliged to accept appointments. Liquidators would have the opportunity to refuse appointment for reasons such as lack of time or expertise, much like barristers.
It is proposed that the cab rank rule would apply only where an officer of the company is, or was (during a certain period), a HRPO. However, the Federal Government has asked whether the cab rank system should apply to all external administration appointments. The consultation paper does not address who should manage the cab rank system or how it should be administered.
Another option that has been put forward in the consultation paper is the introduction of a "government liquidator" to conduct streamlined external administrations of small-to-medium sized enterprises. Private registered liquidators would be appointed in appropriate situations.
The aim of the proposals is to provide company directors with independent and impartial advice on the company's financial position and available options, thereby maintaining market integrity.
Other ideas for reform
Director identification number
While not included in the consultation paper, the Federal Government recently flagged the possible introduction of director identification numbers. The introduction of a mandatory director identification number for all existing and new directors would assist regulators to identify and monitor individuals that are repeatedly involved in phoenix activity.
Reports as to Affairs (RATA)
Another option that has been mooted for reform but is not dealt with in the consultation paper is using the RATA as a tool to warrant further investigation into possible illegal phoenix activity. A RATA is a mandatory report usually drafted by the company directors that must be prepared in certain circumstances (such as the commencement of liquidation of a company) and includes details of the company's financial position. The statutory requirements for RATAs could be amended to include an obligation to report on historical behaviour of directors or the company that may constitute illegal phoenix activity (with appropriate penalties for not disclosing this information). The provision of such information could be used by a liquidator as a catalyst for investigations where a liquidator is suspicious of the company's activities.
The Federal Government will assess feedback received during the consultation period and the next stage will hopefully be legislative reform. We will continue to monitor for any developments in this area.