When it comes to assisting and advising a business facing financial difficulties, it is important to be well informed on all the options open to companies.
When it comes to dealing with insolvency, companies have several options open to them. The choice of which option is best in navigating financial difficulties will depend very much on the size of the business and the scale of the debt. Some options are better suited to SMEs rather than large corporations.
Before looking at insolvency options, let’s recap on what defines insolvency and the difference between insolvency and bankruptcy.
Insolvency is defined as the inability of a company to pay its debts as and when they fall due. Hence, insolvency refers to a financial situation (the inability to pay debts when they fall due). This in turn may lead to bankruptcy – which is one option for dealing with insolvency. Hence, bankruptcy refers to a legal state and bankruptcy is often referred to as an act of insolvency.
Bankruptcy is a legal process by which a party, or other entity, who cannot repay their debts to creditors may seek relief from some, or all, of those debts. Bankruptcy is typically imposed by a court order, often initiated by the debtor. This is known as voluntary bankruptcy. Bankruptcy may also be initiated by creditors who petition the court for the bankruptcy of the debtor. This is known as involuntary bankruptcy.
The period of bankruptcy (ie during which a person is declared bankrupt) is set at 3 years and 1 day. The government is currently seeking feedback on the merits of reducing this default period to 1 year. The argument against this is that it may soften the deterrent aspect of bankruptcy.
Bankruptcy is administered under the Bankruptcy Act. The Australian Financial Security Authority (AFSA) administers the bankruptcy of individuals, whilst the Australian Securities and Investments Commission (ASIC) administers the bankruptcy of corporations.
The bankruptcy process involves appointing a trustee-in-bankruptcy. The trustee must account for all assets and liabilities of the debtor and may sell certain assets of the bankrupt in order to cover all, or some, of the outstanding debts to creditors. The trustee may also carry on a business (at least in the interim).
The advantages of bankruptcy are that it allows the debtor to have a fresh start, as discharge from bankruptcy clears most debts, and it prevents creditors from actively pursuing the bankruptcy once they have declared bankruptcy. However, the disadvantages are that it can impact on a bankrupt’s ability to gain employment (including being appointed as a company director), get credit, or travel overseas. There is also a certain stigma associated with bankruptcy. Hence it should generally be viewed as a last resort.
This is a legally binding agreement between a debtor and their creditors, on how the debts will be handled. A debt agreement administrator is appointed who must prepare a statement of the debtors’ affairs. The debt agreement may involve a compromise on some debts, payment of a percentage of the debts which the debtor can afford, a reorganisation of the debts or payment by instalments. The agreement is a formal method of settling most debts without going bankrupt and represents a good option, particularly for smaller businesses. Debt agreements are administered under Pt IX of Bankruptcy Act.
The default period for a debt agreement to exist is 3 years. The government is currently seeking feedback on the merits of extending this default period to 5 years. The argument against this is that there is the potential for parties to stagnate on the agreement or default on their debts. The flexibility and advantage of debt agreements should remain with creditors. There may be cases where an extended 5-year period is beneficial to creditors, but this is likely to be rare.
The advantages of a debt agreement are that it allows a party to reach a compromise and avoid the stigma associated with bankruptcy. It also allows creditors to receive at least some form of payment, a result which may not be achievable with bankruptcy. However, the disadvantages are that it may impact on a party’s ability to obtain credit, there are debt, asset and income limits to be eligible, it will not release a debtor from all debts, and it will appear on the National Personal Insolvency Index (NPII), albeit for a limited time.
Personal insolvency agreements
A personal insolvency agreement (PIA) is a legally binding agreement between a debtor and their creditors. It involves the appointment of a trustee to assume control of the debtor’s property, prepare a statement of affairs of assets and liabilities, realise any assets, carry on a business (if need be) and make an offer to creditors to pay all, or part of, the debts by instalments or a lump sum. PIAs are administered under Pt X of Bankruptcy Act.
What is the difference between a debt agreement and a personal insolvency agreement?
Whilst a PIA may sound similar to a debt agreement, PIAs offer more flexibility as, unlike debt agreements, there are no debt, asset or income limits for eligibility, there is no statutory restriction on the debtor incurring further debt, and a PIA is not limited to 3 years ie the length will depend on what is negotiated between the parties. A party may also be permitted to retain their assets (such as property or car) if the terms of the agreement allow it. Hence, there are clear advantages associated with a PIA. However, the disadvantages are that it will not release a debtor from all debts.
Creditor’s scheme of arrangement
This is a corporate restructuring process which is regulated under Pt 5.1 of the Corporations Act. It can be used to assist financially distressed, but solvent, companies to restructure their balance sheets in order to avoid voluntary administration and liquidation.
A scheme allows for the creation of a binding agreement between the company and its creditors, which allows the company to continue trading whilst varying the terms of debts or claims between the parties. This may involve the company restructuring the debt owed to affected creditors, allowing for interest-free periods, payment by instalments over an extended period of time or debt for equity swaps.
The advantages of a scheme of arrangement are the options available to restructure debts, the ability to continue to trade, and the fact that, by entering a scheme, a company may avoid the negative effects of administration or liquidation. However, the disadvantages are that entering into a scheme when a company is insolvent may expose the company’s directors to the risk of personal liability associated with insolvent trading, due to the ability for the business to continue to trade. Schemes also require the involvement of both the court and ASIC (which can be costly and timely), the scheme documentation is overtly complicated, and a scheme requires the approval of a majority (at least 75%) of the company’s creditors. For these reasons, many companies facing insolvency prefer to use other options.
The government is currently seeking feedback on whether an automatic moratorium (prohibition) should be applied on creditor claims or enforcement actions during the formation of a scheme, as applies during administrations. The advantage of a moratorium is that it protects against creditor actions and affords financially distressed companies with some breathing space during the process.
Restructuring occurs when a company makes significant changes to its financial or operational structure, typically whilst under financial duress and facing insolvency. However, companies may also restructure when preparing for a sale of the business, a buyout, merger, acquisition, change in overall goals or strategic direction of the business, or a transfer in ownership.
The process involves the appointment of a restructuring practitioner who acts as the company’s agent. Hence, the directors retain control of the company during the process. The role of the restructuring practitioner is to assist the directors in preparing a restructuring plan to be put to the creditors. The plan must specify how company property is to be dealt with.
The advantages of restructuring are that it provides the company with some breathing space to attempt to turn the business around and it allows the directors to retain control of the business, property and affairs of the company whilst the plan is being developed. However, the disadvantages associated with this option are the strict edibility criteria as regards the companies liabilities, and any previous period of restructuring or simplified liquidation. The restructuring plan must be accepted by a majority (in value) of the creditors who are affected by the plan. The restructuring proposal period is also relatively short (30 business days maximum, assuming an extension has been agreed to) which may be insufficient time for more complex restructuring arrangements, particularly for larger corporations.
Following agreements to manage debts, or restructure the company, we enter the more critical options where the debts are clearly unmanageable for a business to survive. The options which follow involve a more invasive level of intervention in the company’s affairs, less power in the hands of the directors and increased scrutiny of the company’s financials.
Administration occurs where an administrator is appointed to a company who is struggling financially. The administrator’s purpose is to conduct an investigation into why the company is insolvent. Voluntary administration occurs where the administrator is appointed by the company directors themselves. Involuntary administration occurs where the administrator is appointed by the creditors.
The administrator takes over from the directors to control the company’s affairs and investigate the insolvency. After the investigation, the creditors meet to decide on the future of the company. The advantages of the administration process are that it provides a company with some breathing space in order to save itself from insolvency. Company assets are also protected during the administration process due to an automatic moratorium on creditor claims. However, the disadvantage of this option is that the directors start to lose day-to-day control of the company, particularly if an involuntary administration occurs. Following investigation there are generally two options:
- Deed of company arrangement – The administrator may recommend that the company execute such a deed if they believe that the company’s financial difficulties can be overcome. The deed is administered by the administrator and governs the relations between the company and its creditors. This includes the payment of debts and may include the release of some debts.
- Winding up – If however, the administrator recommends that the financial position of the company is such that it would not be in the interests of creditors to enter a deed, then the creditors may resolve that the company be wound up (a creditors’ voluntary winding up).
This is a process by which a legally appointed receiver acts as a custodian to safeguard a business or a company’s assets. A receiver can be appointed by a secured creditor (by virtue of the fact that they hold a secured interest) or by the court (court-appointed receiver). The receiver is granted ownership over the company’s property, will conduct an investigation into the company’s affairs, prepare a statement of assets and liabilities, collect funds to pay the secured creditor (which may involve disposing of some of the company’s assets) and may choose to carry on the business if commercially viable.
The terms of appointment may give the receiver the power to manage the company’s affairs. In this case, the receiver is known as a receiver and manager. The receivers’ primary duty is to the secured creditors. The main duty owed to unsecured creditors is an obligation to take reasonable care to sell secured assets at market value or at the best price reasonably obtainable.
Receivership may be corporate receivership or non-corporate receivership depending on the ownership of property over which the receiver has been appointed. For the purposes of this guide, we are focused on non-corporate receivership, which is receivership of property owned by a non-corporate party, such as an individual or a partnership1.
The main advantages of receivership are that the directors still exist and so does the company. In other words, receivership does not necessarily signal the end of the company ie a company may come out of receivership and return to profitability. Receivership also allows a company to pay off a debt to a secured creditor and hence remove that liability from its balance sheet. However, the disadvantages are that the appointment of a receiver severely limits the power of the directors over control of the company assets. In addition, the fact that a company has gone into receivership is publicly known which may affect a company’s reputation, brand and market share.
Unlike administration and receivership (where a company still has the potential to survive), liquidation is more final in signalling the end of a company’s existence. Once a company goes into liquidation, it usually means that the company will permanently stop trading and cease to exist.
Liquidation involves an order to distribute a company’s assets to creditors in order to pay its debts and commence the process of winding up the company. This can be ordered by the court (court liquidation) or initiated voluntarily by the company or its members (voluntary liquidation). A liquidator will be appointed to the company to conduct an investigation, examine the directors and prepare a report as to the company’s affairs. All control of the assets, the conduct of the business, and any other financial affairs are in the hands of the liquidator. Hence the directors no longer have any authority. All company bank accounts are frozen, and employees may be terminated. Business trading can only resume if the liquidator believes it to be in the best interests of the creditors.
Liquidation is the only way to fully wind up a company and terminate its existence. Merely selling company assets and paying its debts still means that the company structure is in place and the company remains in existence. The company structure will survive the process of liquidation but once liquidation is complete, the company is dissolved.
The advantages of liquidation are that outstanding debts can be written off and directors can move on. Liquidation also benefits the marketplace at large, in that it prevents insolvent trading and the risk of zombie companies continuing to exist. The disadvantages of liquidation are clear in that the business, and all its assets, are gone. This has a direct, and very real, impact on employees and creditors. Directors will also suffer from losing control of the business and from the stigma of being associated with a company which has gone into liquidation.
Winding up and deregistration
The final option, where a business is clearly beyond salvage, is to wind up and deregister the company. This step typically follows liquidation. There are a number of options available for winding up a company:
- Creditors’ voluntary winding up – Where an administration process has revealed that the company is no longer viable and the creditor’s resolve to wind the company up. A voluntary winding up can also be initiated by the company members (members’ voluntary winding up).
- Winding up by the court – The court must be satisfied that the company in question is, in fact, insolvent and that there are grounds for winding up. For example, the company has failed to trade, the company has no members, or the directors have engaged in unfair or unjust acts. The power to wind up a company is still at the discretion of the court.
- Winding up by ASIC – ASIC also has the power to wind up a company where the company has not responded to ASIC requests for particulars for over 6 months, the company has failed to lodge required documents in the last 18 months, ASIC believes the company is not trading, and ASIC believes that winding up the company is in the public interest.
The final step is to deregister the company. This can be done by applying to ASIC. Once a company is deregistered it ceases to exist as a legal entity in its own right which means legal proceedings against the company cannot be commenced, or continue, and any property held by the company on trust now vests in the Commonwealth (as represented by ASIC). This presents an issue for unsecured creditors in particular who may now cease to have any recovery options against the company. ASIC can also automatically deregister companies after a set period of time, during which the company has failed to trade or respond to compliance notices.
The advantages of winding up and deregistration are that it allows the company directors to finally move on. The disadvantages are the finality of winding up and the stigma associated with the business venture.
When it comes to assisting, and advising, a business facing financial difficulties, it is important to be well informed on all the options. Advising on the correct option for a particular business will depend very much on the type of business, their volume of debt and where in the process they are ie early in experiencing debt difficulties or far more advanced. Other generic, but essential, factors to consider include:
- The overall economic outlook – Your advice may differ substantially depending on whether there is an economic downturn or recession looming, the possibility for interest rates to increase, a sudden spike in inflation, slow wage growth, staff shortages or increased unemployment. All of these factors will have an impact on a company’s bottom line. The potential for a change in government as a result of the upcoming federal election may also alter the options you recommend.
- Your client’s risk appetite – Some clients will be more willing to stay the course, and perhaps incur further debt in the short-term with a view to turning the company around. Other clients may simply wish to wind up and move on. Really understanding your client and their business is essential in providing the best advice.
As always, if in doubt, seek the advice of a professional insolvency lawyer, insolvency practitioner, tax accountant and/or financial adviser. Once you have thoroughly investigated your client’s situation and the nuances of their particular business, you will need to delve into the particular options you are proposing in more detail.
Rely on our award-winning CCH Pinpoint platform for in-depth commentary on all the insolvency options available to corporations and individuals, to ensure you always stay in the know. Free 14-day trials for any CCH Pinpoint practice area are now available.
CCH Pinpoint, Bankruptcy, accessed 6 May 2022.
CCH Pinpoint, Part IX Debt Agreements, accessed 6 May 2022.
CCH Pinpoint, Personal Insolvency Agreements (Part X), accessed 6 May 2022.
CCH Pinpoint, Arrangements and Reconstructions, accessed 6 May 2022.
CCH Pinpoint, Receivers – Administration, accessed 6 May 2022.
CCH Pinpoint, Court Liquidation, accessed 6 May 2022.
CCH Pinpoint, Winding up by the Court or by ASIC, accessed 6 May 2022.
CCH Pinpoint, Voluntary Winding Up, accessed 6 May 2022.
CCH Pinpoint, Winding Up – General – Deregistration, accessed 6 May 2022.