The government's insolvency reforms, which are aimed at helping small businesses ride out the economic storm caused by COVID-19, are now in effect. These reforms have introduced two new processes – a new debt restructuring process and a simplified liquidation process.

For an explanation of the mechanics of the Small Business Restructuring process (“SBR”), please click here.

It is important to understand the focus of this is on trying to make sure the business is able to continue trading.  This means that the interests of creditors who are owed the money have a much lower priority.  This focus can be clearly seen throughout each of the SBR steps.

While the SBR has a role to play in keeping businesses afloat, it will not be as effective as the government has claimed due to the practical difficulties that businesses, directors and creditors will face. Some of these difficulties are set out below.

Other concerns will be addressed in subsequent articles.

Concerns about the Small Business Restructuring Process

Will creditors continue to supply businesses undergoing SBRP?

To creditors, a business engaging a Small Business Restructuring Practitioner (“SBRP”)  is an obvious red flag that the business is at risk. Any rational creditor will look to stop trading immediately.

While the SBRP tries to stop creditors doing this by imposing, a moratorium on creditors relying on ipso facto clauses1 during the planning period (20 business days) it's unlikely this will prevent creditors from stopping the supply of goods or services to a business as soon as they learn that a business has engaged a SBRP.

Creditors will look to other grounds to stop supply (such as outstanding debts that haven't been paid).  We would also expect that creditors will cease providing credit to that business and all transactions convert instead to cash on demand due to the non-payment.  Many businesses who appoint a SBRP will not have the funds to pay their suppliers upfront.

Relatedly, it is unclear what impact this restructuring process will have on creditors' trade credit insurance policies, which may cease to apply where a creditor supplies a business that has appointed a SBRP.

How creditors are going to respond to an SBRP being appointed is an important consideration and one that will have practical effects for the businesses seeking to use the SBR in order to stay afloat during these difficult times.

Particular risks and traps for creditors of this SBR will be discussed in our next article.

Will the ATO Continue to Pursue Directors for Director Penalty Notices?

It remains to be seen whether the ATO will continue to pursue directors for director penalties in relation to the company's outstanding Pay As You Go (PAYG) and  GST obligations. The amendments introducing the debt restructuring process only require a company to ‘substantially comply' with its obligations to the ATO in order to be eligible to use the process. Although it is presently unclear what ‘substantial' compliance looks like, there is a degree of protection afforded to companies as they do not have to completely meet all their tax obligations.

That protection does not extend to directors- they are still required to comply with all of their obligations.  This is important as the SBR process does require that outstanding tax returns are lodged before the restructuring plan is provided to creditors to vote on.  This means the ATO will be fully aware of the tax obligations of the business.

If the ATO, despite the SBR, continues to pursue directors for those liabilities (including new ones it was not aware of) it may be that the director becomes bankrupt and the business collapses anyway.

Don't Forget the Guarantees!

It is important to understand the SBR process only affects company debts.  Most directors of businesses that are looking at appointing an SBRP will have guaranteed a lot of the debts of the company

As a consequence, business owners will be mistaken if they think that restructuring the business' debts will solve all their financial issues.

A director will still be personally liable for any guarantees they have given under various agreements, including leases, loan contracts, supply contracts and other contracts the business may have entered into.

If the business has not received independent legal advice about exposure pursuant to director's guarantees under various instruments they might be in for an unpleasant surprise even if the SBR is successful.

Is There a Real and Practical Utility to the Small Business Restructuring Process?

As the restructuring process is intended to be available to businesses with liabilities less than a $1,000,000 it will likely be of limited practical utility as many businesses owe more than that in any event.

A much bigger restriction on this process is that with companies this size the vast majority of the financial liabilities relate to employee entitlements and superannuation. As those two liabilities need to be resolved first before the restructuring plan can be sent to creditors this will greatly reduce the ability to use the SBR successfully.

If the directors are also personally liable under any guarantees or other tax debts such as PAYG and GST (if the ATO issues a director penalty notice) then failing to consider these issues and deal with them separately may mean that the SBR process is pointless.

Get Proper Advice

Under the SBR process, the SBRP is intended to act independently. The SBRP may not be able to advise the business owners or directors about the various complex risks that a business owner may be exposed to and other liabilities that the business owner may have.

Our primary concern is that when businesses are in distress, the directors do not consider obtaining proper legal advice regarding their overall financial position as a priority because they do not want to incur any further expenses.  As we have explained above this may still leave them personally vulnerable to bankruptcy or other personal legal action. These issues need to be considered carefully, particularly if the restructuring plan involves the directors putting further personal funds into the business (which we expect will be a common part of any restructuring plan).

We also strongly encourage business owners and directors to seek independent legal and financial advice about their business and any personal risks they might be exposed to prior to starting any SBR.

Footnote

1 Ipso facto clauses are clauses that allow creditors to terminate where there is an insolvency event.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.