Making the hard decisions when confronting insolvency

Tuesday, 01 September 2020


    From selling assets to appointing an administrator, Michael Sloan and Gayle Dickerson, directors of Turnaround Management Association, share key decision points for directors.

    COVID-19 is causing thousands of Australians to make life or death decisions — corporate life or death decisions, that is. So what should every director do when making the hardest decisions in the life of the company? What steps should a director take when deciding to turn off life support and appoint a liquidator? What do you do if you decide to appoint an administrator to help to salvage what is needed to keep the company alive?

    More than 20,000 companies are wound up in Australia each year. Somewhat counterintuitively, the number of insolvency appointments has reduced by around 40 per cent during COVID-19 due to a range of factors, including stimulus, moratoria and insolvent trading temporary relief. The government is actively considering ongoing support and law reform measures to ensure that herds of companies do not fall over the insolvency cliff in the coming months — in particular, fast-tracked and streamlined restructuring and insolvency law reforms. However, a large number of companies, particularly SMEs and NFPs, will face financial distress.

    When a company becomes financially distressed, its directors need to act quickly and prudently to ensure they abide by their fiduciary duties and do the best thing for the company and its creditors.

    The first thing a director of a company in financial distress should do is ensure management is triaging the situation appropriately. The board of any company suffering financial distress should take the following steps:

    • Communicate with financiers Engage and negotiate with financiers about ongoing finance, extending terms or waivers of covenants/defaults or penalty/interest payments.
    • Cashflows Review the company’s cashflows.
    • New debts Move to defer the company incurring new debts to the highest possible extent.
    • Premise leases Exercise caution in renewing any new leases of premises.
    • Fresh equity Explore the injection of fresh equity.
    • Disclosure/notification obligations Consider disclosure and notification obligations under any relevant directors and officers (D&O) insurance policies.
    • Records Keep a record of deliberations regarding the solvency of the company in a file, including:
      • Financial information available from management, including management accounts, cashflow projections and aged creditor reports.
      • Board minutes.
      • File notes concerning the commercial grounds upon which decisions are made as to ongoing solvency.
      • Key summaries of the position of the financiers, in particular the responses to any breaches by the company.
      • Legal, management and accounting advice received regarding solvency issues.
      • Directors need to be cognisant of their duties and behaviours should there be concerns as to the solvency of the company. There are key mistakes directors should avoid, mistakes made in error, wilfully or ignorantly, before appointing insolvency practitioners.
    Flow chart decision tree

    Appointing external administrators

    If a director determines things are bad — and here we’re assuming they are very serious and a workout/pursuit of safe harbour is impossible — an insolvency appointment will need to be made. Two avenues of external administration are available — noting the very largest companies may consider a scheme of arrangement, which allows a company to reconstruct its capital, assets or liabilities with the approval of its shareholders and the court.

    The first is voluntary administration (VA), in which an independent administrator is appointed to take control of the company’s business for a limited period of time to give the company breathing space and resolve its financial future and direction quickly.

    The second option is liquidation, in which a company’s financial difficulties have been determined to be unsalvageable, and its shareholders, creditors or the court may place it into liquidation.

    Crucially, consideration should be given to whether the company’s position is salvageable or terminal. Around 85 per cent of companies that appoint an external administrator end up in liquidation. Directors should weigh up real prospects of survival against wishful thinking. Often, the decision to appoint a VA is left too late, so there is little alternative but to proceed into liquidation.

    How much will it cost?

    How long is a piece of string? It is important to get good advice early, although owners are often reluctant to do so because funds are already restricted. The average cost of an SME liquidation is about $30,000. VA fees typically cost $31,500 and the administration of a deed of company arrangement (DOCA) is $28,700. The average cost for the VA process in total is around $60,000 for companies with assets of less than $1.5m.

    You have a company that is in difficulty, do you use the available funds on fees? However the company is on its knees because it needs solutions — if it were easy, the directors would have worked it out.

    Two things come out of that. Firstly, people really need to put their hands up earlier. Secondly, sometimes — and this includes the professionals — if the company has gone, it’s gone, and you shouldn’t rage against the storm.

    Michael Sloan is an insolvency partner at Ashurst and Gayle Dickerson a partner in deals and advisory with KPMG. They are directors of the Turnaround Management Association Australia.

    8 insolvency missteps and how to avoid them

    It is important for directors to be alert to potential mistakes before appointing insolvency practitioners. These are some of the primary ones to avoid.

    1. Don’t transfer assets for less than fair value There is usually no issue with selling assets or a business as long as fair value is paid. The best way to evidence this is to obtain a valuation prior to selling the assets/business and use this as a guide for what the sale price should be. A sale completed outside of an insolvency might realise a higher value. However, professional advice should be sought, as any insolvency practitioner will closely review transactions completed prior to appointment, especially if to a related party. Alternatively, it may be more appropriate for an insolvency practitioner to undertake a sale process.
    2. Don’t put every last cent into your business Sadly, especially as a business starts to fail, we often see scenarios where directors put all of their personal wealth and assets on the line without a clear turnaround plan. The failure of the business might be delayed by a few months, but the directors’ entire life savings have diminished and it gives them limited future ability to restructure the company out of an insolvency process or restart their lives.
    3. Don’t pay yourself in priority to others Don’t be tempted to reduce director loan accounts or pay other related party debts in priority to unrelated trade creditors. Conversely, one of the first things a liquidator will do is demand repayment of a director’s loan account (or related party accounts) if there is a balance due. This could tip other related companies into insolvency, too. This includes paying director guarantees that may crystallise on insolvency. Frequently, directors are unable to determine which creditors actually hold a personal guarantee because their paperwork is not in order. The creditors that will almost always have a personal guarantee include a financing bank, a landlord and any major suppliers. Understand your personal exposure and ramifications of an insolvency, such as if you have mortgaged your house to the business.
    4. Don’t get unqualified advice Seek quality advice from professionals recognised in their industry. Don’t be lured by promises, cheap fees or low hourly rates as you could be paying more in the long term and incur potentially serious recriminations personally.
    5. Don’t trade while insolvent Trading while insolvent is both a civil and criminal offence. A liquidator (or creditors) can pursue you personally for the debts incurred by the company after it became insolvent. As a director, you need to be across your company’s financial performance and take action if you think your company could be, or could become, insolvent. You may be able to utilise safe harbour protection, which came into force with new laws in 2017, to allow companies in financial distress to gain protection from personal liability for insolvently trading while implementing a turnaround strategy.
    6. Get clarity on the tax position Be aware of the tax position of the company, particularly with reference to director penalty notices (DPNs), which allow the ATO to seek payment of unpaid company PAYG (pay as you go) withholding tax and superannuation from a director. If the ATO is paid PAYG payments ahead of other creditors, and these amounts are later recovered by a liquidator as a preference, the ATO may seek to recover those payments from the director. DPNs can now also make directors liable for an under-reported GST liability accrued from 1 April.
    7. The liquidator is not your friend A liquidator owes their duties to the creditors. Even though you may have chosen the relevant appointee, they are not there to look after your interests. Many directors don’t fully appreciate that when an appointment is made, their powers and control lapse. An appointee will likely work with the director to achieve the best outcome for business and creditors.
    8. Make a plan Even if you have limited time, make a plan with the end in mind. Is there a genuine chance of a restructure, or should the doors be shut for good?

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