The Insolvency Trap

08/11/2012 by Michael Jones

Why Company’s fail

It is very clear from statistics produced by the ASIC that the vast majority of companies fail as a result of poor strategic management.  Other reasons provided by the ASIC include poor cash flow management, inappropriate books and records and trading losses.  However it can be argued that all of the above descriptions really mean the same thing that is poor management.  This is good news in a way in that it means it is not inevitable that businesses fail.  Businesses fail because of the lack of the management skills of the directors and these management skills can be improved if directors focus on the appropriate details.

The Unthinkable

For most small business owners, it is impossible to contemplate the consequences of the failure of the business.  This often means that rather deal with important issues and make the decisions appropriate to good management, directors procrastinate and as a consequence make the situation worse.  In the extreme, I often see companies being wound up by the Court on an application by a creditor.  Obviously if this takes place, a liquidator will be appointed by the Court and that Liquidator will be nominated by the creditor who makes the application.  Sometimes, this liquidator is seen by many to be on a mission and in some cases, the liquidator’s reports may be seen to somewhat exaggerate what others may refer to as minor misdemeanors by the directors.

It is clear that once the company is would up,the director or directors will lose control of the business assets and as a consequence, will no longer have access to the personal income that was previously being derived by the business.

In addition, there may be legal consequences that flow as a result of the winding up and the issues that come out of the Liquidator’s investigation.

Last but not least, there are a number of emotional issues that affect the individual directors when the winding up of the company occurs.

Legal Issues

As a consequence of the income stream being cut off, directors find themselves in a position of not being able to service their personal commitments such as personal mortgages.

In addition, it is common that the company has entered into finance contracts such as equipment leasing and that these contracts are personally guaranteed by the directors.   When the company goes into liquidation, it is usual for the liquidator to either abandon these assets because there is no equity available, or sell the assets at a relatively low value compared with the original purchase price.  In any event, it is common for the finance company to call on the directors to pay pursuant to the personal guarantees.

Trade creditors are often also personally guaranteed by the directors and as it becomes obvious of the company will no longer meet these debts, guaranteed creditors will eventually start putting pressure on their guarantors.

Personal liability can also flow to the directors in relation to certain outstanding debts to the Australian Taxation Office.  Specifically, where the tax office has served a Director Penalty Notice, pursuant to Section 221 of the Tax Act and the directors have not responded in accordance with this notice, the directors are personally liable for the debt on the expiry of 21 days.  More about this later.

In addition to taxation legislation, there is specific legislation corporation’s law that can make directors personally liable in respect of companies that have failed depending on the conduct of directors.  Specifically Section 588 G of the Corporations Law creates both Civil and Criminal penalties in circumstances where directors having incurred a debt in relation to a company that is insolvency.  This is an extremely complicated area and the ASIC has issued guidelines on how directors should conduct themselves in these circumstances.  In practical terms, directors risk personal liability if they find themselves in breach of these rules and in the worst case, can expose themselves to criminal sanctions involving jail sentences.

Emotional Issues

There is no question than when a business fails the individual owners and directors of the business face a number of challenges at a personal level.  At the top of this list is a deep sense of personal failure, coupled with a loss of status and personal prestige.  In some cases, business owners experience extreme anger at their situation, often blaming a plethora of other parties for the situation they find themselves in.

Whether the aforementioned emotional expressions are justified on that or not, there is no questions that individuals in this situation experience an enormous degree of anxiety, particularly as there is a lack of clarity as to what the future may hold.

Sadly, some of these emotional pressures are manifested in marital and family dis-harmony and personal dysfunctional behaviour and in extreme cases, depression. The Australia Taxation Office is often the major creditor in companies that fail.  This is particularly true in private and family owned businesses common amongst Civil Contractors.

What about the Tax Man?

When a business such as a business involved in Civil Contractors gets into difficulties, the payment of statutory obligations is often deferred as the company’s cash flow becomes difficult.  Clearly the priorities of the company will be to meet the important expenses such as the wages, rent and essential supplies and lease payments on equipment without which the company cannot function.  Statutory obligations provide no real benefit to the company’s business and in circumstances government departments are often slow, at least initially in pursuing outstanding debts.  This often becomes a de facto financier of a struggling business.

Recent legislation has been enacted to deal with this situation as the Treasury researches indicated that companies in this situation are frequently closed only to emerge under a new name often very similar with the same shareholders and directors.  This is referred to as Phoenix companies.  Treasury research has referred to fraudulent Phoenix activity as opposed to the legitimate use the corporate form and the recent legislation has been articulated specifically to deal with fraudulent Phoenix activity.  Treasury have also indicated that there is potential loss of up to $600,000,000 to the revenue in relation to this activity.

The main thing addressed by this new legislation is to make directors of company’s personally liable in situations where they have not lodged a BAS statement for 3 months.  Additionally, the legislation includes outstanding superannuation guarantee levies as part of the regime.  The real difficulty with this is educating business owners as to the consequences of this legislation.

Of course for many years the Tax Offices have had the ability to serve a Director Penalty Notice on directors. This notice requires the directors to act within 21 days to do one of the following:

  1. Pay the debt
  2. Come to an arrangement regarding payment
  3. Appoint a Liquidator
  4. Appoint an Administrator

One of the main difficulties with these notices is that they are not served on the company or the company’s tax agent; rather they are served on the director’s personal address which is often out of date.  As the consequences of these administrative difficulties, the notices are often ignored with the consequence that the directors become by default personally liable for the debt.

The form of the notice is also somewhat iniquitous and directors frequently are unaware of the severity of the consequences.

A further development in relation to the Taxation Office of recent times is the issuing of garnishee orders.  These orders are often issued in relation to debts owed to the Tax office to the company’s bankers or major debtors.  The Orders are issued with no warning and have the profound effect of cutting off the company’s cash flow.

Civil Contractors are extremely exposed in relation to these garnishee orders due to the nature of the industry.  Specifically many civil Contractors have one major debtor.  It is easy for the Australian Taxation Office to target this debtor with disastrous consequences.

Finally in the extreme cases, the ATO commences winding up proceedings against the company.  If this takes place the ultimate goal is to have a Liquidator appointed which was described earlier.

Insolvent Trading

The provisions relating to insolvent trading is set out in Section 588 G of the Corporations Law Insolvency is defined using a cash flow test, that is the company’s inability to meet debts as and when they fall due from its own resources.  In addition there is a balance sheet test which often simply looks at the current assets compared to the current liabilities.  Corporations Law sets out Civil liability which if in breach has of consequences of making the directors personally liable and possibly exposed to what is called a Civil Penalty Order.  In addition, in situations where the activity is deemed to be dishonest, there is a criminal liability which involves a jail sentence of up to 5 years.  The ASIC sets out guidelines to how it interprets this legislation and how directors can best discharge their responsibility.  These guidelines can be found on the ASIC website.

Management Responsibilities

In addition to the liability set out under the Insolvent Trading Rules, Corporations Law also mandates a business judgement rule which prescribes a certain degree of care and diligence by directors and other officers of the company and mandates how director should discharge himself in relation to “the business judgement rule”.

In general, directors must ensure whether they maintain proper books and records of the company and receive appropriate financial reports.  Directors should understand the dynamics of cash flow and the consequences of a cash flow on the business specifically to ensure that they are confident the company can meet its debts as and when they fall due.

Directors must understand the importance of profitability and that if a company continues to make losses; these losses need to be funded.  There is a certain source of this funding and a business reason as to why the losses should be continued to be funded.

Directors should understand the basic balance sheet ratios, particularly the current ratios as this has an impact on the determination as to whether the company is not insolvent or otherwise.

Most importantly, directors are required to take appropriate professional advice and finally, to take positive action and to affect change where change is necessary.

Good management is essentially about the personality drivers of the individual directors set out below are the following ten “Ps” of Success which define these personality drivers;

Positive Thinking                              Perception

Perseverance                                     Priorities

Practicality                                        Performance

Perspiration                                      Presentation

Preparation                                       Perspective


The Golden Rule of Turnaround Management

In simple terms “OPPORTUNITIES DIMINISH WITH TIME”.  As a business gets into difficulty and descends further and further down the road to oblivion the opportunities to save the business begin to diminish.

Clearly as the terms of trade get worse and creditor’s attitude towards the company and its directors begin to sour it becomes more and more difficult to persuade the creditors that the company is viable and to obtain their indulgence.  In short credibility begins to diminish and disappear.  Furthermore and more obviously as the situation deteriorates, the directors expose themselves more and more overtly to breaches of the Corporations Law and Tax Law.

Of course as resources start to evaporate the ability to pay professionals for advice disappears.

As the spiral continues downwards and cash flow continues to dry out, directors usually start to take short cuts to keep their businesses alive.  Often these short cuts have disastrous consequences in that the product being supplied to the market becomes inferior and customers begin to complain.  This has an obvious impact on the recovery of the debtors and therefore cash flow and the spiral continues downwards.

In time creditors begin to take legal action and once the matter becomes to the point where statutory demands are issued and winding up notices commence, it becomes more difficult if not impossible to save the day.

Turnaround Strategy

The most important ingredient in implementing a “Turnaround” strategy is to demonstrate the underlying business is viable.

In doing this, it is important to establish the reason why the company is in financial difficulty.  If the reason is clearly identifiable and believable and has been effectively addressed, it is much easier to obtain indulgence from creditors and other stakeholders.

Creditors will almost always consider a moratorium and even a discount on their claim providing it can be demonstrated that, but for the debt the company is viable.

Trade creditors are usually much more concerned about maintaining viable customer into the future then pressing for the immediate payment of a debt.  This of course is a persuasive reason for creditors to vote in favour of a Deed of Company Arrangement proposal.

What are the options?

The first option is for the company to enter into some form of informal scheme with its creditors to “trade out of its difficulties”.  The problem with informal schemes is that they are not binding on any creditors and at any point in time; a creditor can literally break ranks and proceed to wind up the company.  This often means that smaller creditors can hold larger creditors to ransom.  It also provides no protection whatsoever for the directors and officers of the company in relation to insolvent trading and in fact may make the situation worse.  There is also no way of enforcing either a moratorium on creditors or requiring creditors to accept a discount on the amount they are owed other than dealing with each creditor on an individual basis in practical terms, this is extremely difficult.

Another option is to place the company into Liquidation as a Voluntary Liquidation.  These are steps taken by the shareholders of the company who are usually the directors.  A Liquidator is appointed by simply passing a resolution and if the company is insolvent, there is a requirement for a creditor’s meeting within 11 days.  The creditors can if they wish, appoint a different Liquidator but this is rare.

The Liquidator is able to sell the assets or the business as a going concern and there is no legal restriction on directors acquiring these assets from the liquidator and beginning a new business.  This is the legitimate use of the Corporate Form.  Providing the process is transparent, this does not breach any of the anti-Phoenix Legislation and there should be no adverse consequences for directors.

Finally directors can appoint an Administrator of the company to the company with a view to having the company entering into a Deed of Company Arrangement (DOCA).  Administrators can also be appoint by a secured creditor, but is most common that an Administrators are appointed by the directors.  The overall purpose of the Administration is to enable an independent expert to review the company’s affairs to consider its viability, to consider the alternatives that are available and to assist the directors in working out a proposal that can be presented to the creditors with a view to enable the company to trade out of its difficulties.

The proposals put to creditors are not defined by the Act and there are no prescriptions other than these proposals should provide a better return to creditors than would be achieved if the company were to be wound up.  The proposals usually involve a moratorium from the creditors in relation to the payment of the debts and often enforce a discount on the creditors so that some part of the debt is written off.  Most importantly these proposals are submitted to the creditors in a formal way and approved by vote and as long as the vote is appropriately carried it becomes binding on all creditors, thus avoiding the problem that is most often experienced in relation to informal work out procedures.  The steps in relation to an Administration commence with the appointment of the Administrator by the directors and this is done by simple minute and notice.  The Administrator is required to convene an initial meeting of creditors within 8 business days.  This meeting gives the creditors the ability to appoint an alternate Administrator and to appoint a committee if the creditors.

A second meeting is required to be convened within 20 day ± 5.  This meeting is the decision meeting and at this meeting the creditors approve the proposal or wind up the company, or adjourn the meeting for a further consideration and finally have the ability to end the administration.

If the proposal is approved by the creditors at the meeting, a formal Deed is executed between the administrator and the company within 21 days and then becomes binding on all of the creditors.

It is important to note that in order to have these proposals approved; the voting requires that a major in number and value of the creditor paid in favour of the proposal.  If it is undecided, that is if the majority in number and or the value cannot be achieved, the chairman has a casting vote, although it should be noted that this vote is subject to be review by the Court significantly turns on the level of investigation carried out by the Administrator and the voracity of the proposal and whether or not the proposal is in interest of creditors and provides a significantly better return that a Liquidation otherwise do.

Voluntary Administration is particularly to Civil Contractors having regard to the complexity of contracts and the potential of termination.

Position of the Bank

The first question that must be asked under this heading is what security the bank has.

Banks usually have external security in the form of guarantees provided by the directors and often these guarantees are supported by registered mortgage over the director’s personal homes.  Sometimes the banks in addition have fixed and floating charges over the company’s assets.  If the banks has a charge over the company’s assets, it is in a position to appoint a Receiver and in some circumstances this in fact may be in the interest of the directors because it has the effect of protecting the directors in relation to potential short falls which may have an adverse impact on their guarantees.  As indicated earlier the banks ( if they are secured creditors),  have the ability to appoint and Administrator and this can be used to strategic advantage.

Of course banks, like any other creditor, can press for the company to go into Liquidation.  However, in most circumstances a bank will normally rely on their documentation to enforce their security using the Receivership as a main option.

As indicated earlier the banks are usually externally secured and it is important to note that an Administration meeting, the secured creditor is entitled to vote for the full amount of their claim.  That is to say the bank does not have to deduct the value of their security when quantifying the amount of their debt for the purposes of voting.  The effect of this is the banks often have a significant voting power in administration.  Directors can often use this to persuade the bank to consider the wishes of the guarantors when casting their vote.

As the guarantors are usually the directors and as it is usually the directors putting forward the proposal this can be a powerful strategic position in assisting to achieve the desired outcome in relation to a Deed of Company Arrangement.

One important factor that is taken into account in making this determination is an accurate assessment of why the company is in financial difficulty in the first place.

From experience, if the financial difficulty can be determined by a single factor or at least a very limited number of factors and it can be shown that these factors have been addressed in relation to the company’s future trading it is then much easier to demonstrate the viability of the business.

What if my co director will not cooperate?

In some circumstances it is apparent that the director’s minds are not convergent in relation to the company’s future.  This is particularly difficult for a director who believes the company is insolvency or likely to become insolvent and that some formal appointment needs to be made.

The appointment of Administrators requires a resolution of the board of directors, and if the board is split this becomes impossible.  Furthermore the winding up of a company requires a passing resolution equivalent to 75% of the value of the shareholders and again if the shareholders are split on this decision, it is impossible.

It is not sufficient for a director in these circumstances to simply resign.  This does not and cannot relieve the director of his obligations under the Corporations Law and certainly does not relieve that director of any penalty that may follow as a result of the company’s trading activities up to that point in time.  Furthermore, once the individual resigns as a director, he has no ability to control the outcome.

If there is a secured creditor a responsible director may attempt to persuade that creditor (usually a bank) to take control via appointing a Receiver or an Administrator.

Finally and most commonly, directors in this situation are left with the alternative of making an application to the Court for the appointment of a Provisional Liquidator.  This may be the only step available to directors in these circumstances and depending on the size of the company and the size of the debt and the level of the urgency should be considered if the director wishes put forward to him whatever protection may be available.

What if a creditor commences the winding up?

This takes me back to the golden rule of turnaround management, that is OPPORTUNITIES DIMINISH WITH TIME. As already stated this prevents a company from proceeding with a voluntary winding up.  It does not however prevent the directors from appointing an Administrator.  The difficulty is that the Administrator will need to approach the Court and seek an adjournment of the winding up in order for him to carry out the Administration process and put a proposal to creditors.

In seeking the indulgence of the Court, the Administrator must demonstrate that it is in the interest of creditors and it is important to note that in the recent case of Reed Constructions this did not occur and the company was wound up.  Importantly the Court will need to know that there is a viable proposal  simply the possibility of a proposal and that such a proposal will give the creditors a better return than what they would get if the company were to be wound up.  The Court may also take into account the potential voting patterns of creditors to determine whether it is likely that the proposal will in fact be approved.

Experience has indicated that where the Australian Taxation Office is the petitioning creditor, it will insist that the adjournment date requested by the Administrator will immediately precede the creditor’s meeting.  This enables the petitioning creditor, to review the proposal and the report issued by the Administrator so that it can decide whether or not it wishes to press for winding up.

At the adjourned hearing, clearly the Court will have much more information at hand to determine whether it will grant a further adjournment and thus enable the creditors meeting to proceed.

Clearly from the above it can be seen that once a winding up process has commenced, a formal turnaround under Administration becomes far more difficult and any informal agreement becomes impossible.


In conclusion I must reiterate the golden rule of turnaround management “opportunities diminish with time”.