The Plight of the Phoenix: Rising from the Ashes of Corporate Collapse

August 6, 2015

Phoenix rising

Since ASIC launched its tirade on illegal “phoenix” companies and activity in late 2013, we have been involved in a number of cases involving either direct allegations of phoenix activity or a fear of such on the part of company directors. In the vast majority of cases, what we see is not some evil mastermind intentionally ripping people off, as one might expect. Rather, we’re concerned here with mostly everyday, well-intentioned company directors who have failed, often through no fault of their own, and tried to start up again with the least amount of disruption to their stakeholders as possible. The sad part is that, generally, these directors have been completely honest and well meaning, yet face the very real prospect of professional and / or commercial annihilation all the same, unless they can afford what could be crippling legal fees to dig them out of the hole. Worse still, while these efforts may sound noble and sensible, if debts have been left outstanding, the potential liability can be disastrous, and all too often the ideas people have to minimise the fall-out can be the very measures that put them in jeopardy. We thought we’d put some of the lesser-known facts on record here in the hope of helping those innocents avoid potential personal liability, possible disqualification from appointment as a company director and, in some cases, imprisonment.

Although the terms “phoenix companies” and “phoenix activity” are still undefined in Australian law, they are generally understood to describe a situation where a company transfers operations and / or assets to another company in a bid to avoid payments to unsecured creditors. More specifically, the primary concern is with the deliberate and fraudulent avoidance of (mainly) outstanding tax and employee entitlements, usually through the liquidation of the initial failed venture. In practice, what we generally see is one company with a small amount of outstanding employee entitlements, including superannuation, and a crippling tax bill. Usually, in our experience, there are no other unsecured third party commercial creditors with the resources enthusiasm to pursue the debts, but rather only employees of limited means, and of course, the ATO.

For example’s sake, let’s consider a building and construction company called “Top Builders Pty Ltd” (referred to here as “Co. 1”). As is common in the industry, Co. 1 undercut its competitors just to get a job by putting a dangerously low quote out to tender, hoping to make their margins up by add-ons to contract variations arising from a changing scope of works along the way. However, the opportunity wasn’t there, and they end up losing money on the job. They’re contractually bound to continue, and the principal contractor withholds payment until works are completed, so they have to persevere. By the time the job is finished, the company has only just broke even and is managing to pay employees while desperately prospecting for new work, but then, PAYG falls due, along with their quarterly superannuation payments, and they’re doomed. They know they’ll find work soon and everything will be alright in time. However, in the meantime, the small amount of regular maintenance work they have isn’t enough, they can’t obtain finance to pay employees, they can’t afford to make redundancy payments (and want to keep the employees anyway), they can’t utilise trade credit owing to the risk of trading while insolvent, and they certainly can’t afford to pay the bills. While they might pull everything off with time, time is currently against them. What to do?

What a lot of people seem to do, based on advice from their accountant or otherwise, is place the company in voluntary liquidation or administration. Generally speaking, except in cases of serious misconduct and so on, a company provides protection for its directors from personal liability, and as it is a separate legal entity, its outstanding debts tend to die with deregistration (although the exceptions to these two propositions are detailed enough for another few posts themselves). That being so, and particularly if the only creditors are the (overworked and under resourced) ATO and (overworked and underpaid) employees, liquidation might seem attractive, given that it would, theoretically, mean the end of the tax and super bills, with no real harm done to the directors, who would then be free to set up shop through a different company.

Let’s assume then that Co. 1 finds a liquidator and gets the ball rolling. In the meantime, the sole director has set up another company. He names it “Top Builder Pty Ltd” (referred to here as “Co. 2”) (noting Co. 1 was called Top Builders Pty Ltd), in a deliberate attempt to minimise confusion for existing clients and staff, but also (understandably) to retain some personal pride in dealing with trade creditors and so on. The director has also managed to land a big job in the meantime, which will keep Co. 2 busy and prosperous for some time. He also sends a notice to existing clients to inform them of the new ABN and bank account details for Co. 2. Everything seems ok…

Let’s say Co. 1 had purchased machinery, tools of trade and safety gear, which the director carried around in his ute tray, and a few laptop computers, printers and so forth, up to a total value of $30,000. While the staff always used their personal vehicles for work, the director had purchased his ute using a loan in the name of Co. 1, and after depreciation, it was worth about $20,000. So, as at the date of the liquidator’s appointment, the company had $50,000 in assets on the books. However, as most small business operators using the corporate structure seem to do, the director of Co. 1 had forgotten the distinction between the property of the company and his own property, and had taken the ute, along with all the machinery, tools, safety gear and computer equipment. He also offers the employees new contracts through Co. 2, explaining the situation and advising them that they shouldn’t bother with any claims as they won’t get anything out of Co. 1, but he can guarantee them another job on the same terms with Co. 2 to commence in one month’s time, and promises they will never have to go through this again. Given the competitive job market, the employees trust him and do this. All seems to be well for Co. 2 and our director.

When the liquidator of Co. 1 receives the books and records of Co. 1, they are far from complete, as is commonplace. This spurs a more in-depth investigation, and he manages to obtain all of Co. 1’s banking records, loan documents and tax records. He discovers the $50,000.00 in assets on the books of Co. 1, but the assets themselves are nowhere to be seen. He contacts the former employees of Co. 1, who all inform him that our director has advised that they wouldn’t get anything from Co. 1, but has given them new jobs with Co. 2. In compliance with his statutory obligations, he prepares his report to creditors and lodges it with ASIC. The alarm bells start to ring, primarily because of the disappearance of assets without the payment of consideration, the PAYG and super installment payment failures and the fact that the same director has set up a virtually identical company with a strikingly similar name to take over Co. 1’s revenue-generating contracts. To a regulator, it seems like a deliberate attempt to shaft employees and tax. Before long, ASIC and the ATO come knocking…

Our director now faces significant personal liability for all outstanding PAYG withholding payments (i.e. the tax on salaries, commissions, dividends and so on), plus all superannuation guarantee payments, together with interest and penalties. That is, unless he can prove that, for example, he commenced winding up immediately upon discovering the liability, and that he otherwise took all reasonable steps to ensure compliance (i.e. by trying to actually pay these debts).

In relation to the employees, the liquidation could be found to have been a deliberate attempt to avoid employee entitlements. In addition, the statements made could be considered misrepresentations as to the employees’ workplace rights. As such, unless the director can prove that he actually did not intend to avoid the payment of the entitlements, and that he was not even reckless as to his understanding of the employees’ situation (i.e. it didn’t even cross his mind that the employees could have some sort of claim to their entitlements), he could be liable for severe civil penalties and even compensation to the employees.

In relation to the matter generally, and especially regarding the taking of assets, the director could be found to have breached his statutory duties as a director, including the duty to avoid the company trading while insolvent, the duty not to use his position for an improper purpose, the duty to act in good faith, and the duty to exercise his powers and discharge his duties with care and diligence. Such a finding can also result in personal liability for any damage caused (including but not limited to possibly all debts of the company), and need only be proved on the balance of probabilities (i.e. a 50% chance it happened). Worse still, the same facts and allegations could give rise to criminal prosecution for fraud or tax evasion, which could obviously result in imprisonment.

On account of any of our director’s failures, he could face disqualification from holding office as a company director, especially if he has been a director of two or more companies that have been wound up within a few years of each other, and even if he was not to blame for this. In the latter case, ASIC could disqualify him without the need to apply to a Court.

Ultimately, our director is now in a position where he faces complete financial obliteration, career annihilation, the complete loss of his earning capacity and possible imprisonment. That is, unless he spends a great deal of money with good lawyers who can protect him. If he had taken some simple steps and done things differently, such as actually purchasing the assets from the liquidator for a fair price, using a completely different company name for Co. 2 (and being upfront with third parties about it), and saying nothing to employees about their rights (or better still, pointing them in the right direction for Government GEERS assistance), he probably would have avoided the situation entirely.

As the outcome in the above scenario largely turns on its facts, there are a couple of other points worth noting. The first is that, even if our director did not opt for voluntary liquidation (or administration, for that matter), after a sufficient period of inactivity or the failure to lodge compulsory documents, for example, ASIC itself can wind up the company and appoint a liquidator, so our director would have more than likely been in much the same position sooner or later. Any creditor would also be at liberty to apply to have the company wound up in much the same way. The second point is that the same would apply to a more sophisticated corporate structure that deliberately used a separate, compartmentalised company registered for the sole purpose of hiring labour or incurring the group’s liabilities, if another company was registered in its stead and the employment contracts transferred to the new company, for example. The third point is that our director may find himself in the same position even if he appointed his wife or spouse, or a close relative or friend, as the director of Co. 2, if it could be shown that he was still the “controlling mind” of that corporation.

You can imagine how the situation could apply equally, if the facts in the above example were tweaked to relate to your business. As such, this issue could be relevant to anyone operating a business venture at some point in time.

The moral of the story is, there is no quick fix. Perhaps ironically, in cases of insolvency, it pays to buy competent legal and accounting advice from the outset, and this can produce its own returns far greater than the losses you might be dealing with. Further, and although it’s a bad analogy, these matters should be treated much like a Police investigation – do or say nothing until you have consulted your lawyer.

As always, we are available to discuss any related issues, so feel free to contact us.

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