Insolvency inquiry focused on small business
Despite the growing chorus of those calling for a root and branch review of insolvency law and practice the Government is funding a narrowly focused inquiry by the Australian Small Business and Family Enterprise Ombudsman (“ASBFEO”), Kate Carnell.
The ASBFEO announced “The Insolvency Practices Inquiry” will examine:
- the existing insolvency system through the experience of small business
- the degree of transparency of the governance, processes, and costs of practitioners including legal advisers, valuers, investigating accountants, administrators, receivers and liquidators
- how the insolvency of a small or family business may lead to bankruptcy for the owners
- how the framework impacts the practices and fees of insolvency practitioners.
The insolvency experience for small business
The terms of reference highlight an apparent level of naivety regarding the impact of insolvency on small and family businesses.
Directors of small businesses regularly expose themselves to personal liability when they conduct a business using the corporate form.
It is common for many customer supply agreements to incorporate personal guarantees, indemnities and charging clauses in the account application forms completed on behalf of the company. If the company has borrowed from a financial institution the director is likely to have provided personal guarantees, indemnities and third-party security (i.e. a mortgage over the family home) to secure the facility. Further, the Australian Taxation Office’s director penalty notice regime for pay as you go withholdings (soon to be extended to GST) impose personal liability on company directors from the day the sum is payable to the ATO.
Personal bankruptcy is always a risk if a business fails, whether the business large or small.
Insolvency law and small business
Neither personal or corporate insolvency law presently provide a separate regime for small business.
The options for an insolvent company are:
- voluntary administration,
- voluntary liquidation (which may be preceded by a voluntary administration),
- deed of company arrangement (following a voluntary administration) or a court liquidation.
The only statutory option for restructuring of a small business is the deed of company arrangement.
All these options provide for control of the company business being taken over by an insolvency practitioner.
The options for an insolvent individual are either a personal insolvency agreement, voluntary bankruptcy or involuntary bankruptcy. For individuals, the only statutory option for restructuring is the personal insolvency agreement.
Informal restructuring of small business is a possibility. However, it will normally require a great deal of patience and negotiating skills to bring together the traditionally disparate creditors.
Complaints of small business
The complaints of small business owners when faced with a formal insolvency process relate to the cost of the process, the values realised for the business assets and the loss of control of the process.
Our present insolvency laws do not allow for the debtor to remain in possession of the business. The control of the business and its assets are taken over by the insolvency practitioner. Compliance by insolvency practitioners with statutory obligations reduces the return for creditors. Further, the risk profile of an insolvency practitioner will differ substantially from the owner or director of a small business. This will lead to higher costs associated with the ongoing trading of a small business by an insolvency practitioner.
The array of different stakeholders in the insolvency process means the insolvency system relies on independent ethical insolvency practitioners. Confidence in the system is undermined when insolvency practitioners collude with referrers or stakeholders and either fail to fulfill their statutory obligations or engineer outcomes for the benefit of certain stakeholders.
Small business restructuring options
Many speak of the need for a modified insolvency restructuring regime for small businesses. But what would such a regime look like?
Prepacks are espoused as one option to simplify the process of small business restructuring and reduce costs. Put simply a pre-pack is an agreed sale of the business or part of the business negotiated by a company prior to entering a formal insolvency administration and effected by either the insolvency practitioner on their appointment or by the company immediately prior to the commencement of the insolvency administration.
Some insolvency practitioners and advisers believe they can act first for the company in planning and negotiating the sale and then as the insolvency practitioner in completing the sale. The credibility of the process requires a different person to evaluate the sale from the person who advises on and negotiates the sale for the company. Prepacks may reduce costs but they must be closely monitored to ensure the interest of all stakeholders is being satisfied.
Canada’s Bankruptcy and Insolvency Act, RSC 1985 (CBIA) proposal provisions may provide some guidance for those exercising their minds on this issue.
The CBIA is used by small and medium-sized enterprises for business restructuring. It provides a statutory mechanism for the debtor to remain in control of the business whilst formulating a proposal for consideration by creditors with limited involvement of an insolvency practitioner.
The Insolvency practitioner’s role is to ensure creditors are provided with accurate information about the financial condition of the enterprise and the viability of the proposal. Whilst the enterprise is shielded from existing creditor claims management must convince creditors to continue to deal with them whilst the proposal is formulated. Further, the CIBA provides for classes of creditors and requires special majorities in each class to be binding on all creditors of the class i.e. majority in number and at least two thirds in value of the claims.
The big picture
The ASBFEO Insolvency Practices Inquiry and small business insolvency and restructuring is the primary subject of this newsletter.
It is unfortunate the Government has chosen to fund this review with such a narrow focus. It is further evidence of the reactive and piecemeal approach taken by the Government and its agencies to the issue of insolvency reform.
The Government should not ignore the calls for a roots and branch review of personal and corporate insolvency law and practice. The Australian Restructuring Insolvency and Turnaround Association (“ARITA”) have joined the call for a root and branch review of insolvency law and practice.
It is over 31 years since the Australian Law Reform Commission General Insolvency Inquiry (the Harmer Report) and over 27 years since the enactment of the voluntary administration provisions into the Corporations Law.
Since those legislative changes reform of insolvency law has been piecemeal and reactive.
The world has changed greatly in those 30 years. Change is constant and rapid.
Australia’s insolvency laws have served as well, but change is essential to the maintenance of a strong and robust economy and our international competitiveness.
Australia needs a fit for purpose insolvency regime to meet the challenges of the 21st century.
Who knows when the next economic downturn will be upon us?
Some examples of issues that could be considered by a review follow:
- Is Australia best served by the legal separation of the regulation and administration of corporate and personal insolvency law.
- Do our insolvency laws strike the correct balance between debtor and creditor rights?
- How can insolvency law be changed to minimise the destruction of value commonly associated with formal insolvency administrations?
- Is there a better way to deal with insolvencies of SMEs?
- How can costs of administering insolvent estates be reduced?
- Should trading trusts be dealt with by statute rather than by rules of equity in the Courts?
- Can compliance with director’s duties and bankrupt’s duties be improved by law reform?
- How should the regulator of insolvency practitioners be funded?
- Can business restructuring and turnaround be encouraged by law reform?
- Can employees and other involuntary creditors including the ATO be better protected?
- What is required to save more businesses from liquidation and the economic destruction of lives associated with the process?
- Would a cab rank system for insolvency appointments provide stakeholders with greater confidence in the independence of practitioners?
- Should Banks continue to be allowed to appoint receivers?