I first wrote about the impending insolvency deluge on July 7. Back then the commentariat was focused on Victoria’s fresh governmental induced second wave and how the end of JobKeeper was going to spell disaster for the Australian economy.
Ah, the good ol’ days.
In recent weeks, ‘zombie companies’ has become the economic buzzword equivalent of ‘genomic’ or ‘pivot’ or the ill-fated ‘we are all in this together’.
As anticipated, the temporary insolvency measures have not only insulated companies in COVID related distress, but they also insulated many companies which would’ve gone to the wall in any other year. In the period April – July 2020, a total of 2279 companies entered into external administration compared to 3659 for the same period last year. Those figures represent a significant fall despite COVID restrictions and economic uncertainty severely impacting trading conditions. This trend is likely to continue given the temporary measures have been extended to the end of the year. Once the grace period and monetary threshold returns to normal and insolvent trading becomes parlous again, insolvencies will likely surge. Off a cliff.
Last Thursday, and with the intention of helping to mitigate some of this free fall, the federal government announced a proposed small business restructuring and simplified liquidation process. It’s similar to the Chapter 11 bankruptcy process in the United States and allows small business to work together with an insolvency professional to develop a restructuring proposal to put to creditors while the directors remain in control of the business. The creditors then vote on the restructuring deal to determine whether the business can be restructured and continue to operate or whether the directors ought to consider putting the company through the simplified liquidation process.
This new procedure is designed to streamline existing processes and reduce costs and regulatory obligations to ensure more value is retained for employees, creditors and shareholders. The existing process is costly and cumbersome for small business and often leaves little or no value for stakeholders at the other end.
To qualify for this regime, the company must have less than $1 million in debts, be up to date with employee entitlements and have lodged any outstanding tax returns. It’s likely that the process will work better in less volatile economic circumstances as businesses will be better able to plan for a potential restructure. Even so, financial disorganisation and outstanding obligations to employees and the ATO are often the hallmarks of a failing company. So, while many companies may meet the debt threshold, the failure to meet these other prerequisites will divert a proportion of companies to the existing process.
Given this streamlined process will have reduced investigations into director wrongdoing or voidable transactions, the prerequisite that employee entitlements are met provides important protection for employees. If employee entitlements are not met, then the company will be required to go through the standard process which allows for greater investigations; though that process will cost more, there is less room to hide potential wrongdoing. While this prerequisite protects employees, the trade-off for reduced investigations means that unsecured creditors will ultimately bear more risk.
For the purpose of current economic conditions, I query how many businesses will initially qualify to take advantage of this regime. It is not the panacea it is being reported to be in the media. The brutal nature of the current downturn will likely affect the ability for small businesses to qualify under these provisions given that cashflows have been impaired and businesses have not had sufficient opportunity to manoeuvre into a position to restructure. Even if a company qualifies, the practical reality of the current economic environment means that restructure proposals may struggle to gain creditor approval. That is, creditors may also be starved for cash and not be willing to swap debt for equity, and banks and investors may have a reduced appetite for risk and so are less willing to tip money in to recapitalize business. So, while this process will be helpful to an extent, it’s hard to envisage it being a broad soft landing for small businesses to trade out of this downturn.
The insolvency boffins at ARITA remain circumspect about a few practical matters. They are concerned because 78% of insolvencies have outstanding debt of less than $1m, the $1m threshold is too high and will disproportionately affect creditors. Additionally, they are concerned that in many cases there won’t be enough assets to make any restructure feasible due to 60% of insolvent companies having less than $10,000 in assets and 85% having less than $100,000.
Ultimately, the take up of this new regime (if it is passed into law) and its ability to alleviate the surge of insolvencies remains to be seen. Given the lag in economic indicators, we may not see the true extent of this play out until the middle of next year.
In any event, there will be upheaval in the corporate sector. The debate will be limited to the degree.
Caroline Di Russo is a lawyer, businesswomen and unrepentant nerd.
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