The delivery date for the final report of the Australian Small Business and Family Enterprise Ombudsman (ASBFEO) Insolvency Practices Inquiry (the Inquiry) has been extended from 18 February to March suggesting that the situation may have turned out to be more complex than first thought.
The Inquiry, launched in October 2019, was established to investigate the impact of the current corporate insolvency regime on small and family business. In particular, the Inquiry seeks to determine if the current framework results in greater numbers of small and family enterprises being wound-up than is necessary, and, if framework changes have potential to increase the turnaround rate.
As specialists in micro, small and medium enterprise (MSME) insolvency, Shaw Gidley are hopeful that the combination of this inquiry and the Australian Restructuring Insolvency and Turnaround Association’s (ARITA) proposed Financial Recovery Law Reform Commission will address some of the reasons why formal corporate insolvency regimes can fail micro, small and family business.
The Inquiry discussion paper[i] raises the issue of mandatory education for directors prior to appointment, which we fully support.
In our experience, the corporate structure is sometimes pressed upon low margin enterprises and sole traders, for example, large developers requiring tradespersons to be incorporated in order to be subcontracted. These directors know their trade but not the law. Often ignorant of their responsibilities under the Corporations Act 2001 (the Act), particularly around insolvent trading, they risk committing unintended but serious offences.
Education should include directors’ responsibilities and liabilities, and essential business skills for MSMEs such as how to identify looming insolvency, when to get advice, who is qualified to provide advice and what the implications of different forms of turnaround and insolvency actions are.
If insolvency hits, formal corporate insolvency procedures are disproportionately expensive for small enterprise. A white paper published by Sewell & Kettle Lawyers [ii] indicated that a voluntary administration could cost between $50,000 and $200,000, with 2014 research finding an average cost of $97,000.
According to the Insolvency Practices Inquiry Discussion Paper [iii] 78% of insolvencies in the 2017-18 financial year had estimated assets of less than $50,000. So, it is easy to see how external administration can strip a small enterprise of assets, prevent turnaround and leave the owners reeling in its wake.
We believe that pre-pack insolvency arrangements could be used to greater effect to reduce costs and preserve value where insolvency catches out otherwise viable MSMEs.
Pre-packs are an informal insolvency procedure that involves the sale of an insolvent enterprise as a going concern to a related party either before or after appointing an insolvency practitioner (IP). The process is used more broadly in the UK where the administrator arranges the sale before the enterprise enters administration, whereupon the administrator reviews the sale and, if legal, ratifies it.
Australian law however requires strict separation between the arrangement of the sale and the appointed administrator who reviews it.
Pre-packs differ from illegal phoenixing in that the business and assets are sold for commercial consideration, there is no intent to defeat creditors rights to payment and the assets and operations of the business are preserved.
The pre-pack regime has potential, on a case-by-case basis, to enhance the likelihood of turnaround. Though it has been viewed suspiciously because of past misuse, we believe that there is adequate legislation to allow an appointed administrator that reviews a sale to identify if offences have occurred and take appropriate action.
Pre-packs are most effective when company directors acknowledge insolvency early and act quickly. And, it is important that they receive guidance from appropriately qualified and registered insolvency and turnaround practitioners to avoid the risk of illegal phoenixing.
We look forward with interest to the Inquiry final report and to progress towards a fit-for-purpose MSME insolvency framework.
[i] ASBFEO (2019, December). Insolvency Practices Inquiry. Discussion Paper. Retrieved 17/1/2020 https://www.asbfeo.gov.au/sites/default/files/documents/ASBFEO-insolvency-inquiry-discussion-paper.pdf
[ii] Sewell, B. (2013, March 14). What you need to know before you pre-pack (to avoid phoenix activity). White Paper for professional advisers of SMEs about pre-pack insolvency arrangements. [White Paper] pp 10 & 11. Retrieved 22/1/2020 https://sklawyers.com.au/white-papers/pre-pack-insolvency-arrangement/
[iii] ASBFEO 2019. Ibid p.9.