Australia: phoenixing reform rising beyond the safe harbour

by DLA Piper
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Australian insolvency law reform is gaining momentum. In September 2017, we saw the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 receive royal assent, introducing a new safe harbour for directors who pursue legitimate restructuring efforts. Reforms to ipso facto provisions were also introduced and are due to take effect from July 1, 2018.

Having sought to protect directors when introducing the safe harbour reforms, the government has now shifted its sights to target directors and their advisers. The government has announced a number of proposed reforms in its "Combatting Illegal Phoenixing" consultation paper, which aims at deterring and disrupting illegal phoenix activity and removing the unfair competitive advantage that flows from it. It also aims to minimize any unintended impacts on legitimate business and honest restructuring.

We explore some of the key issues in the current legal landscape regarding illegal phoenixing and the proposed reforms below.

A phoenixing offence

Phoenixing refers to the creation of a new company to continue the business of another company that has been deliberately put into an insolvency process to avoid paying its debts. The act of phoenixing is traditionally regulated by way of common law and statutory director duties. There is no specific offence or provision which deals with illegal phoenix activity. The lack of specific provisions dealing with phoenixing makes it difficult, if not impossible, to deter and regulate such behaviour. The Bankruptcy Act 1966 dealing with personal insolvency contains a number of provisions that deal with the transfer of assets for the purpose of defeating creditors. However, no corresponding provisions exist in the Corporations Act 2001.

A number of proposed provisions have been designed to prevent illegal phoenixing. These proposals include amending the Corporations Act to make it an offence to transfer property from one company to another if the main purpose of that transfer was to prevent, hinder or delay the process of that property becoming available for division among the first company's creditors. Additionally, the proposal is to extend the offence to those who are knowingly involved in the illegal phoenixing activity under section 79 of the Corporations Act.

In terms of remedies, it is proposed that where the Australian Securities and Investments Commission (ASIC) or a liquidator suspects that illegal phoenix activity has occurred and that assets have been transferred for no or less than their market value, then a notice may be issued upon the transferee requiring that company to deliver property or money's worth. The recipient of the notice would have the right to apply to court to set aside the notice.

Other phoenixing remedies

ASIC has the power to bring action against directors who breach their directors' duties. Remedies include banning orders, civil penalty orders and compensation orders. However, banning orders are unlikely to deter persons who facilitate illegal phoenix activity unless they manage corporations. Compensation orders and civil penalty orders are also insignificant deterrents where persons who facilitate illegal phoenixing often have few assets in their name.

Under the proposed amendments, contraventions of the Corporations Act relating to the failure to maintain adequate books and records, and the failure to provide them to an insolvency practitioner in a formal insolvency, would be deemed to be a "designated phoenix offence". This would result in a director being deemed a Higher Risk Entity (see "Targeting higher risk entities" below).

The government is also considering whether both liquidators and ASIC should be able to claw back assets or compensation from the transferee; whether liquidators, ASIC and creditors should be able to pursue compensation for the loss caused by illegal phoenix activity from directors of the transferor, transferee, and from others who are knowingly involved in the illegal phoenix activity; and what civil and criminal penalties should apply to phoenix activity, including against those who are knowingly involved in illegal phoenix activity.

Director appointments and resignations

Under the Corporations Act, a company has the responsibility of lodging a notice with ASIC informing them of a director's appointment or resignation within 28 days of it occurring. Directors have the discretion of lodging a notice of retirement with ASIC; however, no time period is stipulated within which they must notify the company of their retirement or resignation. Accordingly, a discrepancy can arise where a director alleges that a resignation notice was provided to the company but the company has not communicated this to ASIC.

This is open to exploitation by companies, since they bear the liability for making the necessary lodgements with ASIC. For example, companies can back-date a director's resignation so that the director cannot be held liable for offences committed after that time; and back-date a director's commencement of a different "dummy" director (who could be fictitious or deceased) prior to the period when the offending conduct occurred to shield the real director of the company.

It is proposed that the Corporations Act be amended to include a rebuttable presumption that where a change in director notice is lodged more than 28 days after the date of the director's resignation, the director could be held liable for any misconduct that had occurred up to the point of lodgement. Further, it is proposed that the onus for reporting director resignations be shifted from the company to the resigning director.

Abandoning a company

It is possible for a sole director of a company to resign without notifying ASIC, since the liability falls upon the company to do so. This can leave a company "abandoned" and without a natural person's oversight. Accordingly, a phoenix operator may undertake trading for a period of time with no directors in place, strip the company of its assets and leave behind unpaid debts. This may occur until such time as the company is placed into external administration by a creditor via court proceedings or is deregistered or administratively wound up by ASIC.

In order to address this issue, it is proposed that the Corporations Act be amended so that a sole director's resignation be deemed ineffective unless a replacement director is found or the company's affairs are wound up. Alternatively, it is proposed that abandoning a company in such a manner be made an offence.

Extending the Director Penalty Notice regime to GST

The Director Penalty Notice (DPN) regime only applies to pay-as-you-go withholding (PAYGW) and compulsory superannuation contributions (through the collection of super guarantee charge (SGC)). It does not apply to a company's unpaid GST (goods and services tax) liabilities. This allows directors to claim GST input tax credits for their costs and expenses, collect GST from customers, not report their liability to the ATO (Australian Taxation Office) and then liquidate the company so they pocket the GST for personal gain.

It is proposed that the DPN regime be extended to include companies' outstanding GST obligations. This will allow the ATO to recover penalty amounts equivalent to the GST. Directors would be personally liable.

Targeting higher risk entities

There are no preventative or early intervention measures which can be used to disrupt phoenix activity. This makes it difficult for regulators to prevent phoenix activity from occurring. For example, it is possible for suspected phoenix operators to still select their own liquidator, who may be a conflicted one; seek tax refunds while being overdue on forms that give rise to tax liabilities; and exploit the 21-day notice period under a DPN to dispose of or transfer assets.

It is proposed that a mechanism for identifying and targeting the "most egregious" phoenix operators be introduced. The proposed mechanism involves a two-step process. Namely, the designation as a "Higher Risk Entity" (HRE) and being declared to be a "High Risk Phoenix Operator" (HRPO) by the Commissioner of Taxation.

An entity would be designated as an HRE where (among other things) they have previously been disqualified from managing a corporation; they have been an officer of two companies which have entered liquidation in the previous seven years in certain circumstances; they have been found to have committed a phoenix offence (see above) or the subject of promoter penalty sanctions; or they are an officer of an entity which has a poor regulatory compliance history.

Once entities have been identified as HREs, it is proposed the Commissioner would have the power to declare them to be an HRPO. This declaration would be made on a case-by-case basis taking into account the surrounding circumstances. The Commissioner would be required to notify the entity that it has been declared an HRPO and that the declaration would be subject to review. Where an HRPO is an officer of a company, the Commissioner would have the discretion to declare that the company also be declared an HRPO.

Providing the ATO with the power to retain refunds

The ATO can only retain refunds in specific circumstances. Where a business has lodged a business activity statement (BAS) resulting in a refund, but has failed to lodge the overdue income tax return, the ATO is obligated to refund the credit. There can also be a large gap between the due date for lodgement of notifications that may result in a refund (eg, a BAS) and notifications that may result in a liability (eg, an income tax return). Accordingly, in that time a director can strip the assets from the entity that they intend to be left with the debts.

It is proposed that the Commissioner be allowed to retain a refund that would have been refunded to the HRPO in circumstances where the HRPO has an overdue lodgement or notification capable of affecting a tax liability. This means that the HRPO must lodge all outstanding notifications that are capable of affecting tax liability before a refund is issued.

Conclusion

It is clear that there are loopholes in the current system that phoenix operators exploit to the detriment of creditors and for personal gain. Such behaviour can have a significant impact on the economy and ultimately undermine confidence in the legal and regulatory regime. On the surface, the proposed phoenixing reforms appear promising and seem to address at least some of those loopholes. However, it is important that any reforms should strike an appropriate balance between deterring and disrupting illegal behaviour, on the one hand, and supporting the values of innovation and entrepreneurialism promoted by the recent safe harbour reforms on the other. We will continue to monitor further developments in this field.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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