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Insolvency overhaul announced for small businesses

On 24 September 2020, the Federal Government announced significant reforms to Australia’s insolvency framework with the aim of better serving Australian small businesses, their creditors and employees. The proposed reforms seek to enable more small businesses to restructure to survive the financial hardship of the COVID-19 pandemic and, where a restructure is not possible, access to a simplified winding-up process to enable greater returns for creditors and employees.

Overview

The reforms are slated to introduce two new insolvency processes. The first is a ‘debtor in possession' model (DIP Process).  This means that directors and owners of a distressed small business would maintain control of their business while restructuring their company's debts with the support of creditors. This represents a significant shift in the insolvency laws in this country and a step away from the predominantly creditor led and controlled processes. The second is an expedited liquidation process, called the ‘simplified liquidation pathway’, which would streamline winding-ups to allow for a faster and more cost-efficient liquidation. 

These restructuring processes are set to become available to small businesses from 1 January 2021 with some transitional measures to be put in place prior to that date (which are discussed below). This will coincide with the planned cessation on 31 December 2020 of the temporary suspension of insolvent trading liabilities and the increase to the threshold and time for meeting statutory demands – measures that were introduced to help protect businesses at the beginning of the pandemic. It is interesting to note that the Treasurer’s media release does indicate that the Federal Government is planning on undertaking a consultation as to whether the minimum threshold for statutory demands should be raised permanently.

The reforms have been driven by a recognition that the current insolvency processes may be inappropriate for many small businesses.  Government numbers suggest that 76% of companies entering into external administration in 2018-19 had less than $1 million in liabilities and of these, around 98% are estimated to be businesses with less than 20 full-time equivalent employees. These are the companies which are likely to make up the wave of expected insolvencies in early 2021, when the temporary measures currently in place come to an end and it is this wave the government is keen to address. 

Please click here to read the official joint media release of the Treasurer and Minister for Housing and Assistant Treasurer and the fact sheet on the reforms. 

Outlined below are summaries of the new processes based on Government announcements to date. It is anticipated further details will be released during the course of the deferred 2020-2021 Budget expected to be handed down on 6 October 2020.

DIP Process

  • The process will be available to incorporated businesses with liabilities of less than $1 million. 
  • The process requires the board of a company to resolve to appoint a small business restructuring practitioner (SBRP), who would assist the board in developing a restructuring plan.
  • A business would be given 20 business days to formulate the restructuring plan that would need to involve a plan to trade out of distress and a compromise offer for creditors. 
  • The SBRP will certify the plan based on their assessment of the company’s financial affairs. 
  • The SBRP will not be required to take on personal liability for a company or manage its day to day affairs. 
  • The restructuring plan, accompanying information and the certificate are made available to creditors.  
  • The creditors will be given 15 business days to vote on accepting the proposal as outlined in the restructuring plan.
  • The business can continue to trade during the 35 business days period but must lodge any outstanding tax returns and meet all employee entitlements.
  • For the plan to succeed, creditors representing more than 50% in value must endorse the plan, and if this is achieved it binds all unsecured creditors. Creditors vote as one class.  
  • Secured creditors are bound by the plan only to the extent their debt exceeds the realisable value of their security interest. 
  • If this happens, the business continues to trade, and the SBRP oversees the distribution of any funds as outlined in the restructuring plan.
  • Key creditor rights will be preserved. For example, there are no changes to the rights of secured creditors, and similar types of debts are treated consistently. 
  • On commencement, unsecured and some secured creditors are prohibited from taking actions against the company, personal guarantees cannot be enforced against a director or one of their relatives, and a protection from ipso facto clauses (that allow creditors to terminate contracts because of an insolvency event) apply (with the same protections applying as during voluntary administration).
  • As a measure to support the integrity of the process, related-party creditors are not entitled to vote on a restructure plan and a company or its directors can only use the process once every seven years to avoid phoenix activity. 
  • The SRBP will not be required to take on personal liability for a company or manage its day to day affairs.
  • The SBRP can halt the process at any stage if misconduct is identified. 
  • If the restructuring plan is not approved, the company can go into either voluntary administration or liquidation (including the simplified version outlined in further detail below).
  • The process will not be available to small businesses until 1 January 2021. However, as a transitional measure, small businesses will be able to declare their intention to utilise the new process via the ASIC published notices website. Upon issuing such a declaration, an eligible business will be covered by the existing temporary insolvency relief (insolvent trading and statutory demand thresholds) for a maximum period of 3 months. The ability to issue such a declaration and benefit from the temporary relief will be available to small businesses until 31 March 2021. 

Simplified liquidation pathway

  • The simplified liquidation process would be accessible to incorporated businesses with liabilities of less than $1 million (the same threshold that would apply to the new restructuring process).  
  • The simplified liquidation process will retain the general framework of the existing liquidation process, with modifications to reduce time and cost (such as streamlining requirements for meetings and reporting). 
  • As currently occurs, the small business would appoint a liquidator who will take control of the company and realise the company’s remaining assets for distribution to creditors. The liquidator will also still investigate and report to creditors about the company’s affairs and inquire into the failure of the company.
  • The rights of secured creditors and the statutory rules as to the payment of priority creditors such as employees will not be modified.
  • Key modifications include:
    • reducing the circumstances in which a liquidator can seek to clawback an unfair preference payment from a creditor that is not related to the company; 
    • only requiring the liquidator to report to ASIC (under section 533) on potential misconduct where there are reasonable grounds to believe that misconduct has occurred; 
    • removing requirements to call creditor meetings and the ability to form committees of inspection; 
    • simplifying the dividend process (where creditors receive a return proportionate to their debt) and the proof of debt process (where creditors provide information as to the debt they are owed, which is assessed and accepted or rejected by the liquidator); 
    • maximising technology neutrality in voting and other communications; 
    • safeguards will be included to prevent companies from using the process to undertake corporate misconduct, including firms seeking to carry out illegal phoenix activity. This includes allowing creditors to convert the liquidation back to a ‘full’ process and preventing directors from using the process more than once within a prescribed period (proposed at 7 years); and
    • company directors seeking to use the process would also be required to declare that they believe the company is eligible and has not engaged in illegal phoenixing.

Our view and potential concerns 

Our initial views and concerns are outlined below based on the information to date. We hope that many of our concerns are addressed as the legislation is refined.  

DIP Process 

  • High-bar to accessibility – Many companies will not have the financial means to pay-out employee entitlements to access the new DIP Process.
  • Ongoing supply risk – If a company or business can continue to trade, it will continue to incur debts during the period proposed for the new DIP Process. If that company or business is insolvent, suppliers are heavily exposed for potentially 35 business days (ie 7 weeks). 
  • Cram down on unsecured creditors – Secured creditors may attempt to ‘cram down’ on other unsecured creditors in a predatory way if all that is needed is a 50% majority by value. For example, suppliers of goods on retention of title may render worthless the unsecured obligations given by a borrower to the lender.
  • Credit risk evaluation for lenders – The introduction of the DIP Process will necessitate changes in the credit assessment process undertaken by lenders to small business including traditional banks who provide essential transactional facilities as well as small business lenders. This may lead to constraints on the availability of critical banking and finance products for small businesses at a time when many businesses will be trying to trade up and out of financial difficultly. This will be particularly heightened while the new restructuring process and its practical outcomes are untested and largely unknown. 
  • Cross collateralisation – while there is a proposed stay on enforcement of personal guarantees, it is not clear whether this will extend to circumstances where lenders have their exposure to the business cross-collateralised against the mortgage of the personal home of a director. Such cross-collateralisation is extremely common for small businesses and, unless enforcement on such cross-collateralised assets is also stayed, may lead to further difficulty for some businesses in accessing the new process.
  • Manipulation of financials – Companies could theoretically attempt to manipulate their financials to minimise their accrued liabilities to access the DIP Process. For example, this may encourage innovative phoenix operations despite the SRBP being able to halt the process if misconduct is identified. 
  • Interplay with the statutory demand regime – It remains unclear how this new process might interact with the statutory demand regime which is due to revert to the original thresholds and timeframes. For example, if a statutory demand has been issued by a creditor and is ‘live’ and the debtor originates the new DIP Process, which has priority? 
  • Healthy debts need to be reconsidered – The new insolvency process may encourage ‘off balance sheet’ financing, such as receivables financing, where companies seek to shift the risks of payment to suppliers onto non-bank lenders. Lenders vulnerable to the new process will likely want to ensure that they control 50% of the vote, which has implications for their broader book of debts and so the strength of their securitised asset pool that they rely to draw on funds. 
  • Mindshift – the DIP Process represents a fundamental shift in Australian insolvency law which until this point has been creditor led. Time will tell whether lenders, creditors, suppliers, advisors and indeed directors themselves are ready for such a shift. 

Simplified liquidation pathway

  • Sensible and necessary – in our view there will be a large volume of terminal insolvencies (i.e. liquidations) when the temporary measures and JobKeeper subsidies end. The proposed simplified liquidation process is necessary to allow for these situations to be dealt with swiftly, cost-effectively and allow otherwise valuable resources, capital or individuals not to be tied up unnecessarily. 
  • Maximising amounts available – the simplified liquidation process should maximise amounts available for creditors by reducing administrative costs. 
  • Zombie companies – the introduction of this process provides the perfect opportunity for both Government and lenders to deal with the source of zombie companies and pressure directors of such entities to take action. 
  • Assetless Administration Fund (AA Fund) increase – the Government should consider an increase to the AA Fund to ensure liquidators have sufficient funds to undertake appropriate investigations and also consider expanding the funding to cover a capped remuneration and expenses component where appropriate. 

The Hamilton Locke finance, restructuring and insolvency team have a broad range of top-tier experience acting for a variety of stakeholders in distressed scenarios. For more information or advice on how these changes may impact your business or insolvency and restructuring advice generally please contact Nick Edwards, Zina Edwards and Brit Ibanez