In turbulent times it is often tempting to look for avenues to protect your assets and business. One such path may be to restructure an ailing business, and to start afresh with a new entity. However, the pitfalls of such a process can be severe, with a poorly managed transition or a dishonest transition falling within the ambit of the Corporations Act 2001 (Cth) (‘the Corporations Act’).
What is Phoenixing and why can it be illegal?
The process of restructuring an old business into a new entity is aptly known as ‘phoenixing’. The risk that is run is of the business returning to the ashes if the process is mismanaged. Illegal phoenixing occurs when a company is in distress and its assets are transferred to another company or entity for below market value. This new entity will often be controlled by the same director(s) and have a similar name. Once the assets are transferred the debts are left with the original company, with the new entity operating debt free. The old company then goes into liquidation but with no assets to sell, creditors are left unpaid.
It is important to note that phoenixing can be legal in some circumstances. This is often called ‘business restructuring’ and a prominent example is General Motors, which went through a restructure in 2009. Where a director responsibly manages the company and has complied with their legal obligations, acting in the best interests of the company and entering arms-length commercial agreements they may seek to restructure the business. By transferring the assets in an arms-length agreement for market appropriate prices the old company is left with the funds to repay creditors during the liquidation process.
Phoenixing issues occur where there is an ulterior motive and the restructuring would be to the detriment of creditors and the business community. This detriment occurs by depriving creditors their rights to be repaid and by providing an unfair advantage to the new company. When the assets are transferred for less than market value, the new company not only operates debt free but also has lower operating costs by not having to provide the appropriate capital for the assets or pay out entitlements to employees. Illegal phoenixing therefore harms not only creditors but sub-contractors, employees and ultimately the business community and society more generally as governments have to subsidise outstanding employee entitlements.
An example of illegal phoenixing activity is the case of ASIC v Sommerville, where directors were advised that selling the business on the open market would be impractical and disadvantageous and were instead told to transfer the business to a solvent entity. The assets were transferred to a new business with a class of shares that gave the old business the right to receive dividends up to the agreed value of the assets transferred. However, the payment of these dividends was effectively optional, and the court found that the basis of the transactions was to keep the benefit of the assets without the burden of the liabilities.
With all the noise that illegal phoenixing has created it seems fitting that one of the mechanisms brought in to help combat it should be called ‘the DIN’. The DIN (Director Identification Number) is a mechanism contained in recent legislation which will require directors to have their own unique identification number. The effect of this legislation is yet to be seen, with the DIN requirements only becoming enforceable upon proclamation by the Governor-General, or automatically after 24 months after the legislation receives Royal Assent, which was on 22 June 2020. However, once in effect every director will be required to have their own unique DIN, allowing the Australian Securities Investments Commission (‘ASIC’) to track and manage directors who have engaged in phoenixing or other illegal activities.
The penalties for illegal phoenixing can be severe with prison time up to 10 years. ASIC also has powers to reverse the transaction made and civil penalties can be applied by the court, with a maximum of up to $1,050,000 for individuals. Once the DIN provisions come into effect, anticipated to be sometime in 2021, there will also be penalties of up to $21,600 or in some cases one year imprisonment, depending on the offence.
With the possibility of such severe penalties it is crucial that care is taken when considering restructuring an ailing company. Ensure that you seek professional help when thinking about restructuring or if you are facing financial difficulties in your business. If you require assistance with your business or dealing with credit issues such as through the Personal Property Securities Register or the Security of Payment Act 2002 (Vic) regime, contact our Corporate & Commercial team to help guide you through the processes.