Debtor in possession or VA-lite? The Government's insolvency reforms to support small business

The Federal Government’s proposed "insolvency reforms to support small business" are widely reported – the biggest headline being the adoption of a US-style "debtor in possession" model. Unlike the US, the Australian model is for micro and small business insolvencies. In fact, it may be more aligned with the United Kingdom’s new procedure, which came into force on 26 June 2020 after swift advancement through Parliament. It is likely the legislative process will result in a "lite" version of our current voluntary administration process for businesses with liabilities of less than $1million and include a stripped-down version of the liquidation process.

Australia’s current insolvency laws treat micro, small to medium and large enterprises operated through companies the same. To effect a restructuring, the directors of a company enter voluntary administration (VA) and hand control of its operations to an administrator, who is also a registered insolvency practitioner. The administrator develops a restructuring plan in consultation with the directors. During this phase they decide whether to trade on or close the business. The administrator compares the plan to the alternative course of liquidation and recommendations are made by the administrator to the company’s creditors on the best course of action. The creditors decide whether to accept the restructuring plan or to liquidate the company. It is considered a "creditor in possession" model.

There are important differences in the proposed January 1 reforms. Primarily, they allow control of the company to remain in the hands of the directors throughout the restructuring plan. The directors engage a "small business restructuring practitioner" (SBRP) to advise and guide them through the various stages: development of the plan, approval by creditors, and implementation. It is a "debtor in possession" model. There is logic to leave the company in the hands of those who know it best. But is the fox in charge of the hen house, and could unscrupulous advisers prey on directors to the detriment of creditors?

We hope that the consultative process on the draft legislation, good sense in Parliament and regulations over time will result in a regime with adequate safeguards. However, the Government has left itself very little time to consult with experts in the insolvency profession and academia, and to then draft, pass and implement the legislation.

While the devil will be in the detail of the draft legislation, we make the following brief observations on some of the statements in the Government's fact sheet:

• "The process will be available to incorporated businesses with liabilities of less than $1 million". How will liabilities be measured? Will it be current and non-current liabilities? What about contingent liabilities? Damages claims? Many SMEs will not meet such a strict line in the sand.
• "Business owners will be able to trade in the ordinary course of business when a plan is being developed..." however "a [SBRP] will not be required to take on personal liability for a company". Most businesses rely on its suppliers extending credit to trade. If the SBRP is not personally liable for ongoing trading debts, which suppliers will deliver on anything but COD terms? How will the already struggling business pay COD for all supplies and services?
• "...prior approval of the small business restructuring practitioner [SBRP]...will be required for trading that is outside the ordinary course of business". For some businesses, this will involve almost daily monitoring by the SBRP or their staff. That comes at a significant cost to the business, countering the aim of providing a cheaper restructuring path.
• "Qualifications required to register as a [SBRP] only will be in line with the streamlined requirements of the role. Registered liquidators will also be able to manage the new process". This suggests that lesser qualifications than those held by registered liquidators will be sufficient to act as a SBRP, which opens up the potential for unregulated advisers to take on this role; potentially the same advisers that facilitate the bane of phoenix activity in our economy. We think it will be prudent to engage a registered liquidator as the SBRP, which ensures a higher level of accountability.
• "…not all small businesses will be able to access the process immediately on 1 January 2021, after the existing temporary insolvency protections expire on 31 January 2020…To address this transitional issue, an eligible small business will be able to declare its intention to access the [process] to its creditors…" Getting these transitional provisions correct is going to be critical to so many companies, so as not to expose them to statutory demands soon after 31 December 2020 and for their directors to maintain the exemption from insolvent trading liability. Note also the public declaration of the need for a restructuring plan, which may lurk on credit reports for a business for years to come.
• "Safeguards…to prevent…corporate misconduct…include a prohibition on related creditors voting on a restructuring plan". While this safeguard is welcomed, we still have doubts that it will prevent misconduct. For example, a related party might be able to assign its debt to an unrelated party who would then be able to influence the outcome.
• "…unsecured and some secured creditors are prohibited from taking actions…a personal guarantee cannot be enforced against a director…a protection from ipso facto clauses [applying]…" These important protections will be drawn from the current voluntary administration regime, making these reforms very much a "VA-lite" proposal.
• "The business must pay any employee entitlements which are due and payable before a plan can be put to creditors". This is potentially one of the biggest stumbling blocks to a take-up of these proposed reforms. Often, micro and small businesses that have got to the stage of requiring a restructuring plan are well behind on providing for the due and payable entitlements of their employees. These businesses may be unable to raise or borrow additional funds to meet this requirement, and who will lend it to them?
• "If more than 50 per cent of creditors by value endorse the plan, it is approved and binds all unsecured creditors". Thus, one or two creditors may end up holding the day on a creditor's vote, which weakens the position of small unsecured creditors in the process. The Government's fact sheet is silent on whether any options will be included for creditors to challenge the outcome of an unfair vote by creditors or the provision of inadequate information to creditors on the restructuring plan.
• "If voted down, the process ends, and the company owners may opt to go into voluntary administration or to use the simplified liquidation pathway proposed…" The option to move to VA seems wasteful, as the same creditors will then be voting on any restructuring proposal that is put forward in that process. It will be interesting to see what the "simplified liquidation pathway" will entail.
• "The simplified liquidation process will retain the general framework of the existing liquidation process…Time and cost savings will be achieved through reduced investigative requirements, requirements to call meetings, and reporting functions". The fact sheet promises safeguards to protect against corporate misconduct that may arise from this simplification, including illegal phoenix activity. The best safeguard would be the Government providing an ongoing fund that can be readily accessed by registered liquidators to assist them to investigate.
• "Key modifications [of the simplified liquidation process] include:…Reduced circumstances in which a liquidator can seek to clawback an unfair preference payment from a creditor that is not related to the company". This is a concern, as it means that large, business-critical and assertive creditors will be able to get themselves paid first and in full over smaller and less critical creditors. It encourages the very self-help behaviour that can force financially distressed companies into liquidation in the first place.

This week, the CEO of the Australian Restructuring Insolvency & Turnaround Association (ARITA), the key insolvency professional body, described the proposed reforms to us as the "Swiss cheese we're having to work with". He is correct; like a Swiss cheese, there is plenty of tasty substance to these proposed reforms, but also plenty of holes.

We will keep SME owners/directors and their accountants informed of developments as the Government releases its draft legislation, hopefully for public consultation, and as the reforms are implemented in time for 1 January 2021. SMEs that wish to utilise these reforms to restructure in early 2021 from the damage caused by COVID-19 would be wise to get early, confidential advice from our experienced insolvency team as the draft legislation emerges.

Author: Keiran Breckenridge, Special Counsel

Our team is actively monitoring and considering the implications of legal and regulatory developments in response to the COVID-19 pandemic. You can find our COVID-19 collection here.