A step too far?

The government’s proposal to reduce the term of bankruptcy from three years to one year has been the subject of recent debate. This proposal forms part of the government’s National Innovation & Science Agenda.

Some insolvency practitioners have recently expressed reservations regarding this proposal. Is the proposal a step too far?

Punitive origins of bankruptcy

Bankruptcy historically was a punitive process. Failure to pay your creditors was regarded as akin to stealing. It was regarded as a moral issue. The consequences of insolvency could be harsh in early civilisations. A creditor could enslave the debtor and his or her family or kill or maim the debtor. In the UK during the early industrial revolution, debtor’s prison became a relatively more humane punishment compared with those previously imposed. The concept of discharging a debtor from bankruptcy and forgiving their financial sins, is only a relatively recent phenomenon.

Rehabilitative process

Today bankruptcy is considered a rehabilitative process. The bankrupt is subjected to a regime that provides a release from debts on discharge from bankruptcy. For most bankrupts that occurs three years after the lodgement by the bankrupt of a statement of affairs and its acceptance by the official receiver. The bankrupt can re-enter the commercial world after discharge free of the burdens of the obligations incurred prior to the commencement of the bankruptcy.

Purpose of bankruptcy law

Whilst the process has evolved from punitive to rehabilitative, its basic purpose remains the same. That is to provide an orderly mechanism to realise the bankrupt’s assets for distribution rateably among creditors. Its purpose is to minimise the financial loss suffered by creditors who are financially exposed to the bankrupt through the imposition of a collective process. In other words, it represents a mechanism for creditors to recover some part of their debt.

Encouraging innovation?

AFSA report that in 2013/14 there were 29,514 personal insolvencies. 63% of these were bankruptcies. 

81% of these administrations disclosed the cause of the administration as non-business related or cause unknown. The largest non-business cause disclosed was unemployment and the smallest personal guarantees. Only 19% of personal insolvency administrations were attributed as business related. Based on these statistics only approximately 20% of bankruptcies can be attributed to the conduct of business. The remaining bankruptcies have non-business causes. 

In 2014/15 there were 28,288 personal insolvencies, 61% were bankruptcies.

It would appear questionable whether the proposed reform will encourage genuine entrepreneurial activity by providing an earlier discharge. The reform will assist in destigmatising bankruptcy. It will also assist those whose bankruptcy was brought about by genuine misfortune to make a fresh start earlier. 

However the question must be asked is bankruptcy law reform the appropriate mechanism to encourage innovation? There appears to be a real disconnect between the interests of creditors and the stated purpose of the changes proposed by the government. 

Who will benefit?

The well advised whilst inconvenienced, do not suffer real hardship whilst bankrupt. They rarely lose their home, or their lifestyle.

Efforts by the legislature to access the assets accumulated by the well advised have been largely ineffective over the past 30 years. Good ideas like accessing assets of controlled entities were made so complicated to be next to worthless. Efforts strengthen these provisions to facilitate their effectiveness were beaten down through intense lobbying by professional and business associations. The changes proposed did appear to go too far and had retrospective effect. The ultimate timid changes have had little or no impact on the effectiveness of the provisions.

Regrettably the saying 'there’s one law for the rich and another for the poor' appears to have some validity when considering the effect of bankruptcy law on an individual.

The most effective tool provided inadvertently to bankruptcy trustees by the legislature is the income contribution regime. The regime allows the trustee to assess the value of monetary and non-monetary benefits provided to bankrupts by third parties as income. These include use of motor vehicles, payment of expenses and accommodation which are common means of maintaining a bankrupt in the lifestyle to which they are accustomed. This results in the contribution of money to the estate by the bankrupt for the benefit of creditors. Failure to pay results in the extension of the period of bankruptcy by the lodgement by the trustee of an objection to discharge.

Whilst the assets of third parties utilised and accessed are not available to creditors of the well advised, their use by the bankrupt is defined as income.

The reduction of the period of bankruptcy will particularly benefit the well advised bankrupt. The well advised will be subject to the income assessment regime for only one year before they are discharged. Further they may manage to arrange their affairs so as to avoid receiving any income, monetary or non- monetary benefits during that short period.

A trade off?

If the government intends to push on with their proposal the interests of creditors must be acknowledged and satisfied.

Consideration should be given to strengthening the powers of the trustee in return for reducing the period of the bankruptcy. Changes could be formulated to assist the trustee access property acquired directly or indirectly through the activities of the bankrupt in the five years prior to being made bankrupt, whether used by the bankrupt or not.

The impact of bankruptcy should be seen to be borne equally by all who become bankrupt. Creditors should be entitled to access the fruits of a bankrupt’s activities. It should not depend on the quality of advice the bankrupt was able to afford before becoming bankrupt.

This would represent a fair trade off for the reduction in the term of bankruptcy.
 

If you have any questions in relation to this article, please contact your local RSM adviser or David Kerr.

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