ILLEGAL PHOENIX ACTIVITY: A GUIDE FOR DIRECTORS
Navigating insolvency is always challenging - legally, financially and operationally. As a result, it can be tempting to listen to pre-insolvency advisors who promise to wipe your company's debt through a simple restructuring process.
In most cases, though, evading creditors by transferring your assets to a new company isn't just unethical - it's also illegal. Illegal phoenix activity has been practiced in Australia for decades, but, with regulatory and law enforcement powers increasing, it's more important than ever to comply with legislation.
In this article, we'll explore exactly what illegal phoenix activity is, what you can do to avoid it, and how you can legally resurrect an insolvent or near-insolvent company.
CONTENTS
- What Is Illegal Phoenix Activity?
- Pre-Insolvency Advice: What to Avoid
- How to Legally Resurrect a Company
- Next Steps: How to Move Forward
WHAT IS ILLEGAL PHOENIX ACTIVITY?
When a company is liquidated in Australia, its debts are paid out from the company's value. If the company's assets can't cover the debts, its creditors are left unpaid or 'defeated'. This limited liability helps protect economic activity - if directors or company owners were personally liable for a failed business's debts, far fewer people would start businesses.
Illegal phoenix activity occurs when a new company continues the business of a liquidated company to avoid paying its debts. Its name is derived from the mythical Greek bird that, upon death, is reborn from the ashes of its former self.
Typically, phoenix activity starts with a new company being incorporated; often, the directors of the existing company will resign, appoint dummy directors (who may sometimes be appointed unknowingly), then become directors of the new company.
Once the new and old companies exist side by side, the old company's assets and business are transferred to the new company. Assets are normally sold for much less than market value, which helps preserve capital for the new company.
Examples of assets and business commonly transferred during illegal phoenix activity include:
- Employees who were previously employed by the old company
- Client accounts and projects
- Business premises
- Bank accounts and financial software
- Marketing collateral like websites and ad accounts
- Contact details, including phone numbers and emails
- Hardware, furniture and other physical assets
Once the assets have been transferred from the old to the new company, the old company is liquidated or abandoned, leaving creditors, employees, and sub-contractors unpaid. Often, tax liabilities are also voided through illegal phoenix activity.
Often, directors who engage in illegal phoenix activity are aided by unscrupulous pre-insolvency advisors - unregulated 'advisors' who have networks of friendly valuers and liquidators and specifically help companies defeat creditors.
ILLEGAL PHOENIX ACTIVITY VS. LEGAL PHOENIX ACTIVITY
Not all phoenix activity is illegal. In some cases, starting a similar company after the first one has failed is legal.
Phoenix activity, itself, is not a crime. It's the actions involved that are often illegal. The duties of directors are regulated by the Corporations Act 2001 (Cth) s 588, which prohibits actions that lead to 'creditor-defeating depositions of company property' - in other words, you can't sell off company assets in a way that a reasonable person would know defeats creditors.
There are, however, exceptions. Disposition of company property can occur - even if it defeats creditors - under:
- A compromise or arrangement approved by the Court under s 411, in which creditors/liquidators reach a compromise with the company
- A deed of company arrangement, in which the company's share capital is re-arranged
- A restructuring plan made by the company, the company's liquidator, or the company's provisional liquidator
Often, a pre-packed restructuring plan is the best way to legally 'phoenix' a company. The key is that directors must act responsibly during restructuring - they must act in the best interests of the company and its creditors, and assets need to be transferred to the new company at their true market value. This allows creditors to get paid from the asset sale, rather than being left out of pocket by undervalued or hidden asset transfers.
There are also other aspects of the Corporations Act 2001 (Cth) that need to be considered, such as fraudulent concealment and removal of assets and fraud by company officers.
PENALTIES FOR ILLEGAL PHOENIX ACTIVITY
Illegal phoenix activity is a serious crime - it can directly impact creditors, employees and sub-contractors, as well as indirectly affect taxpayers through government compliance efforts and unpaid taxes.
A 2018 report, The Economic Impacts of Potential Illegal Phoenix Activity, estimated that illegal phoenix activity costs Australia between $2.85 billion and $5.13 billion per year. Broken down, that looks like:
- $1,162-$3,171 million not paid to trade creditors
-$31-$298 million not paid to employees
-$1,660 million in unpaid taxes and compliance costs
As a result, the penalties for illegal phoenix activity are extensive. Company directors and secretaries can face up to 15 years in prison and heavy fines; other parties to the crime, such as pre-insolvency advisors, can also receive fines and jail time for aiding and abetting illegal phoenix activity.
PRE-INSOLVENCY ADVICE: WHAT TO AVOID
There's a fine line between legally and illegally resurrecting a company. To avoid breaking the law, getting the right advice is critical.
Avoid pre-insolvency advisors, especially those who approach you directly. Illegal phoenix operators often engage in cold outreach with insolvent or near-insolvent companies, before using their network of friendly valuers and liquidators to fraudulently transfer assets and defeat creditors.
Instead, talk to a commercial lawyer or financial professional you trust. With the right advice, you can guide your company out of insolvency legally through mechanisms such as pre-packing via voluntary administration or restructuring.
In the next section, we'll explore each of those techniques in more detail.
HOW TO LEGALLY RESURRECT A COMPANY
If you're a director of a company that's at risk of insolvency (or already insolvent), then it's important to think about a legal path forward.
In addition to the requirements around creditor-defeating depositions, you also need to be careful about not trading when the company is insolvent. Under s 588G of the Corporations Act 2001 (Cth), the company can't incur a debt if:
- it is already insolvent at the time the debt is incurred;
- by incurring the debt, the company becomes insolvent; or
- there are reasonable grounds to suspect that the company is either currently insolvent or would become insolvent if it incurred the debt.
Breaching s 588G can result in both civil (compensation, fines, and/or disqualification from directorship) and criminal (a fine and/or up to five years in prison) penalties.
Importantly, though, there is an exception to those obligations - s 588GA, the 'safe harbour' provision for directors. If you suspect that the company may be or becoming insolvent, you can continue to trade as long as your course of action is reasonably likely to lead to a better outcome for the company. Keep in mind that the burden of proof is on you, so make sure you keep any necessary documentation to prove that you've complied with the provision.
Once you've made sure that you're compliant with s 588G, you can look at ways to legally phoenix your company.
PRE-PACKING THROUGH VOLUNTARY ADMINISTRATION
In the United Kingdom, an insolvent company can be legally resurrected through a 'pre-pack administration'. This is a legal process through which a business and its assets are sold to another company as a going concern. A sale of the business from the current company to the new company is 'pre-packaged' and then assessed and ratified by an insolvency practitioner - to be legal, the sale must be likely to produce the best outcome for creditors.
Unlike the United Kingdom, Australia doesn't have a formal pre-pack process. Instead, a company can be resurrected using the mechanism we talked about earlier in this article, where the business and its assets can be sold for fair market value to another entity.
To avoid being classed as illegal phoenix activity, this process has to have two key elements:
- The directors must act in the best interests of the company and creditors, and not act dishonestly or recklessly with the intention of defeating creditors.
- The business and its assets must be independently evaluated by a valuer and sold at fair market value.
The process for a pre-pack insolvency normally involves three steps:
- The company's business and assets are independently valued. Legal, operational and financial advice is obtained in relation to pre-packing.
- The business and/or assets are sold and transferred from the old company to the new company at the independent valuation. Employees may also be transferred, with the new company often accepting any entitlement liabilities.
- A voluntary administrator (or liquidator) is appointed to the old company to take the appropriate actions. They also investigate and ratify the appropriateness of the sale.
Pre-packing is a legally grey area, so getting advice from an experienced commercial lawyer is the best way to make sure your activities are all fully compliant.
RESTRUCTURING FOR COMPANIES WITH UNDER $1 MILLION IN LIABILITIES
Under certain circumstances, you can appoint a restructuring practitioner to legally restructure your company. To be eligible:
- your company can't have liabilities exceeding $1 million;
- the current directors of your company, or any directors 12 months before the practitioner's appointment, can't have been directors of other companies that underwent restructuring or simplified liquidation in the past seven years (with certain exemptions); and
- your company can't have been restructured or gone through a simplified liquidation process in the past seven years.
A restructuring practitioner helps your company prepare a restructuring plan that helps the company discharge its obligations to creditors. This plan includes information like:
- What company property should be dealt with and how it should be dealt with
- The remuneration the restructuring practitioner will receive for their services
- The date on which the plan was executed
The plan can't include:
- Provisions for property transfer (other than money) to creditors
- Provisions to pay creditor claims under the plan more than three years after the date of acceptance
Note that most taxes that are typically associated with the sale of a business can often be avoided in these circumstances, so long as the required information and relevant disclosure are made to the government bodies.
Once the plan is created, it's presented to creditors, along with the plan's standard terms, the restructuring proposal statement, and a declaration from the restructuring practitioner. Each creditor must then provide written statements as to whether or not the plan should be accepted and whether or not they agree with the practitioner's assessment of the creditor's admissible claims and debts (covered in the proposal statement).
Before giving the plan and accompanying documentation to creditors, your company must:
- pay the entitlements of employees that are due and payable; and
- submit returns, notices, statements, applications or other documents as required by taxation laws.
Once a plan is accepted, it's legally binding for creditors, your company, your company's officers and members, and the restructuring practitioner until the plan terminates.
As a mechanism for saving an insolvent/near-insolvent company, restructuring has a number of benefits, including:
- During the plan's creation, creditors can't enforce claims against your company without the practitioner's or the Court's permission.
- During the plan's creation creditors can't enforce personal guarantees against a director, their spouse, or relatives.
- You and any directors remain in charge of your company during the restructuring period, and you can continue dealing with the company's assets in the normal course of business (practitioner consent is required for dealings that are not 'normal').
You can view a comparison of restructuring and voluntary administration (which is available to all businesses) here.
VOLUNTARY ADMINISTRATION
Voluntary administration can, in some circumstances, be a mechanism for saving your company. Unlike the other two mechanisms, though, voluntary administration means you and any other directors hand over control to the administrator.
Voluntary administration also has three possible outcomes, with the decision being made by creditors:
- Control of the company can be handed back to you and any other directors.
- A deed of company arrangement (DOCA) can be formed.
- Your company can be liquidated.
This means that choosing voluntary administration is normally a last alternative to liquidation -administrations often end in liquidation anyway, so pre-packing or restructuring can, in many circumstances, be a better option.
NEXT STEPS: HOW TO MOVE FORWARD
If your company is currently insolvent or nearing insolvency, liquidation isn't the only outcome. Pre-packing, restructuring, or even voluntary administration can all help you move forward - either under a plan to achieve solvency or as a new entity without the liability burden of your old company.
To determine which mechanism will help you achieve the best outcomes for your company and your creditors, seek the advice of an experienced commercial lawyer. They'll be able to advise you about legally sound pathways, as well as make referrals to other relevant professionals like business consultants and financial advisors.
Importantly, avoid anything that could be construed as illegal phoenix activity. ASIC and other regulatory bodies have extensive powers relating to surveillance and law enforcement around illegal phoenix activity; there's even a dedicated Phoenix Taskforce, which was specifically formed to identify and crack down on illegal phoenix operators.
