Insolvency (Part 3): How to Legally Restructure a Business Through Pre-Pack Transactions

0:00
You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

Welcome back to another episode of Explain That by Velocity Legal, joined by Director Demian Walton, director of our Velocity Legal Disputes and Insolvency team.

0:23
Demian, we've been talking in Part 1 about what's an insolvency, what are the risks, what is available to creditors.

Part 2, we've flipped it around to business owners, what options are available to them, whether SBR, voluntary administration or otherwise.

0:39
And at this part, we're going to be talking about this pre-pack transaction or how to save a business through a proactive restructure.

And I'm really looking forward to deep diving into this because it sounds like if this is available, it could be a really ideal solution.

0:57
But at the same time, it sounds like if you don't do it right, you get to bear a lot of wrath.

Let's just unpack that pre-pack term.

Yes.

What do we mean by that? Because we'll be using that term throughout this part.

Yeah. So pre-pack essentially is having a plan before you appoint an administrator or liquidator.

1:21
It's having a plan to transfer the business operations into a new entity either before you make the appointment or shortly afterwards.

Yeah. Now the classic pre-pack, in Britain they have a formal procedure for this where a registered insolvency practitioner will supervise this to ensure that it's done fairly, doesn't disadvantage creditors.

1:55
We don't have that here, but the Corporations Act leaves room for us.

Probably a good way to introduce the topic is to talk about phoenixing and it's important not to do, and then define what you can do by virtue of what you can't do.

2:13
Yes, yes, because you can't transfer something under value and therefore rip off creditors.

A few years ago, and probably for quite a long period of time up until 2019 when new provisions were inserted in the Corporations Act to deal with this problem, there were a lot of unscrupulous pre-insolvency advisers out there, essentially snake oil merchants who would offer a magic solution.

2:50
Yes, for, you know, pay them $10,000, they'll make your problems go away.

Yes, fantastic. Sounds good.

Good. So all you have to do is you set up a new company, you change the name of the old company to something else, you change the name of the new company to the name of the old company.

3:10
You change the ACN on your letterhead.

Yeah, close on a Friday, start on a Monday, and everything's the same except for a different ACN and ABN.

Yeah, it's not a nice thing for suppliers to find out who've been left behind, or the ATO dollar, or employees.

3:29
And at its worst, homeless people were being signed up to be directors of the old company, and it was just kind of left until eventually someone takes action.

3:46
Yeah.

And the directors of the new company say, oh, we've had nothing to do with that company for months.

I suppose illegal phoenixing essentially involves transferring the business from one company to another, not paying adequate consideration or not paying any consideration.

4:10
Often there's not even a sale agreement, and that approach is obviously not to be recommended.

And so in 2019, new provisions were inserted in the Corporations Act to more directly attack those kinds of transactions.

4:34
And they've always been unlawful because they involve breaching directors' duties, they involve deception, they involve uncommercial transactions.

But they've made it easier.

Yeah, it's to prosecute.

Yeah, easier to prosecute.

4:53
Liquidator doesn't have to prove as much to get the sale of the transaction set aside.

There are new penalties and new liabilities that can arise, so directors can be ordered personally to pay compensation where this has occurred.

5:18
If it occurs recklessly, that's now a specific criminal offence.

Okay, so possible jail time.

Jail time, fines, not just directors but also their advisers.

Because, Demian, it's anyone involved in a phoenix, isn't it?

5:36
So, you know, the snake oil salesperson.

So it means that not only directors but also advisers need to know what they're doing.

Yeah.

5:52
And I guess if there's a line, then they would want to make sure well and truly that they're nowhere near that line, on the right side of the line.

Where is that, or what is the difference between an unlawful phoenix and a lawful one or a pre-pack transaction?

6:14
So the essential provision, and I'll read the relevant wording, so it's section 588FDB of the Corporations Act.

So it defines what's called a creditor-defeating disposition.

6:32
And this occurs where the consideration payable for the disposition, that is the transfer or sale, is less than market value or less than the best price reasonably obtainable in the circumstances.

6:51
And it prevents, hinders or delays property becoming available for the benefit of creditors in a winding up.

So conversely, if you have a transaction that doesn't do those things, it's not going to fall foul.

7:07
Yes. And if the court finds that that's what's happened, yes.

And it can make orders declaring the transaction void. It can order the return of property back to the company. It can order the purchaser to pay the company an amount that represents the value of the benefits received by the purchaser.

7:32
Yeah, under the transaction.

Yes. And the court can also order the directors to pay damages.

Pretty severe. Voiding transactions, compensation, including from directors personally, and I suppose also that risk about fines and all that if it's really egregious.

7:52
Yeah, it's also very expensive to litigate, I suppose on the plus side.

Dodge.

Yeah, if, if.

On the plus side, a liquidator is probably not going to pursue it unless there's enough value in it for creditors.

8:13
Yeah, because it would ultimately require there to be sort of a creditor with enough.

Yeah, and it has enough money to fund the litigation.

On the other hand, if you have transferred a valuable business, you'll end up paying a lot more to acquire it.

8:32
Yes, than you originally planned for.

And I suppose the risk is probably more the ATO, that might not be necessarily about the commerciality. It might be that wanting to set an example or make a test case out of one where, okay, then the cost of the litigation might be more than what's there for that case, but it sends a message clearly to others.

8:56
Not so much.

Okay, not so much.

ASIC might do that.

ASIC might do that, yeah.

There's a prosecution. That said, ASIC is notoriously under-resourced.

There is one decision.

9:12
Well, there's at least one decision called Re Intellicomms where there was a creditor who was sufficiently enraged.

Yep, and well-heeled.

9:30
To fund very expensive litigation to set a transaction aside.

So this creditor was actually a minority shareholder in the company.

Yes.

A company that provided telephone interpreter services, and the minority shareholder had provided the software platform that was used in the business.

10:00
The business had operated for about 10 years or more. It had some blue chip clients like Optus, Telstra, Origin Energy, the New Zealand Government and others.

According to the director, because of COVID, there'd been a downturn and this had resulted in service fees owing by the company to the minority shareholder for use of the platform building up.

10:30
Yes, yes.

So there were negotiations between the director and the shareholder to try to persuade the minority shareholder to put more funds in to enable the business to keep going.

In order to advance those negotiations.

10:51
The director got the valuation of the company at $11 million.

The minority shareholder wasn't convinced by that value.

Another valuation was obtained at $600,000.

11:06
A big difference.

A big difference. Negotiations still fell through.

So what the director did was she got another valuation which valued the company, well, valued the business at $60,000.

11:23
Oh.

So $60,000, $600,000 and $11 million.

And $11 million. After deducting employee leave entitlements that were assumed by the new company, $18,000 was paid for the business.

11:39
See why that might enrage somebody?

So that would enrage somebody.

There were proceedings in the Supreme Court, ended up in a trial with senior and junior counsel on both sides.

The purchaser said, Mr Liquidator, you have to prove how much this business is worth.

12:02
You haven't done so. Our expert says it's worth $20,000. Therefore, the court should approve the transaction.

The judge sort of wasn't having a bar of it, commented on the fact that both sides were spending millions to try to get control of this business.

12:27
So it was probably worth more.

They're spending that much combined over it, so it must be worth something.

It was probably worth more, and the judge described it as brazen and audacious as an example of a phoenix transaction.

I mean, that sounds like they really fell down. Value is hard to determine, but it sounds like it just wasn't a reflection of the value of the business at all.

12:53
Yeah. So I mean value can be in the eye of the beholder, and valuing businesses is as much an art as it is a science.

But what the director had done is she'd given different forward profit forecasts.

13:16
So not comparing apples to apples now, are you?

No, no, no.

She did eventually rig it.

Yeah, well, that's probably not worth the paper they're written on then.

No, no, not worth it.

That's possibly an extreme case of, you know, brave, brazen and audacious behaviour.

13:36
But I do sometimes see transactions where, you know, directors come to me after it's already happened and they think, well, we got an accountant's valuation, that's what they said it's worth, why should we pay any more?

13:55
We've done nothing wrong, etcetera, etcetera.

But these sort of valuations are, you know, sometimes they do it at an asset realisation basis, because, you know, there are different methodologies of valuing businesses.

14:16
Sometimes they rely on the fact that the company has been operating at a loss the last three years and then assume that will continue.

So really, the business is worth nothing, instead of making a realistic assessment of the future profitability of the business.

14:33
Sounds like to do these properly, I mean, you really need to sort of do that proper valuation and really sort of always deal well, really dealing at arm's length, isn't it, because you've got to be seen as the party that's going to pay the most for the business.

14:52
I suppose if we go back to that definition in the Corporations Act of a creditor-defeating disposition, you've got to pay market value or the best price attainable in the circumstances.

15:09
That's easy to say, but not easy to work out. You know, when you have Caesar passing judgement on Caesar.

Yeah, I mean, I've heard anecdotal stories about, you know, the cafe owner and, you know, they sold the cafe to another entity.

And yeah, the cafe owner is the person who's going to realise the most value, and no one else is going to buy that.

15:31
It's not going to be every situation, but that's sort of the vibe sometimes, that no one else would pay as much as this new company anyway.

Well, that's true.

And that's the natural advantage that the existing business owner has over the rest of the world in being the successful purchaser of the business.

15:57
So an approach that I often recommend is rather than getting a valuation, which is expensive and can be contested, what you do is you set up a new company, you license the use of the company's assets by the new company for the duration of the VA period.

16:25
Yeah, or for a period of time after a liquidator is appointed.

This means that the liquidator comes in, or the administrator comes in, they can advertise the business and try to get the best price.

Now, a sale by liquidator is not going to generate the kind of price that a business owner wanting to get the best price for their business is going to achieve.

16:54
And that's not because of anything devious.

Yeah, it's because liquidators.

So if the liquidator sells a business, they're not going to be willing to give warranties, all the usual warranties the business owner will give.

Yes, to kind of reduce the purchaser's risk.

17:14
Yeah, the liquidator would just probably say take it or leave it.

I'm not promising anything. I don't know. I would have been here five minutes.

Yeah, how would I know what's happened four years ago? And I'm definitely not guaranteeing it.

Whereas a business owner might say, well, yeah, okay.

17:29
I've been intimately involved.

So I can give that warranty because I'm not worried about it.

But the business owner can't be required to do that in a liquidator sale, which would give to the business owner essentially a privileged position over others.

17:46
The other sort of important feature of the liquidator sale is that generally or almost always, there won't be restraints of trade to protect the goodwill of the business.

So even if the third party buys the business, there's nothing to stop the business owner setting up in competition.

18:08
Yeah, good point.

If the liquidator was to sell it, then, well, you know, the individuals not guaranteeing any of that.

And then how much would you pay for something that the person who was running it isn't restricted in any way? You have to discount it by that.

18:24
Yeah. So I suppose if you go to that cafe example, instead of, you know, trying to convince the court or creditors that no one else wants the business or no one else is prepared to pay as much, it's instead of going down that path where you can have litigation, give the liquidator or administrator the opportunity to test the market.

18:48
Yeah. And is that license agreement arrangement, is one of the drivers around that, that then the administrator isn't racking up debts which it could possibly be liable to, whereas where it's licensed to someone else, it's someone else incurring the debts?

19:05
Yes, yeah, yeah.

So if you're parachuting the administrator and the A-team of staff to try to run this business fresh, which they don't know much about, yeah, they're going to be very expensive.

19:21
Yeah, very disruptive. It can really do bad things to the goodwill of a business.

Whereas if you just have the business continue under the same management but in a different entity, it's the best way to preserve value and ultimately to get the best outcome for creditors, get the best outcome for the business owner.

19:50
Yeah. Well, I think that's a great end note that ultimately, you know, what we're talking about here in this part is what's in the best interests of creditors, which I think, you know, that's always going to be the primary consideration, and it might be the best thing for creditors is to restructure to another entity.

20:08
Just don't make the illegal phoenix.

Yes.

I want to thank you, Demian, for being part of this series.

In this part of the series we've been talking about pre-pack transactions, how they can assist.

It's been a fascinating discussion. I've learned a lot throughout.

And of course, if anyone does have any questions, I'm sure that you're happy to be reached out to via the website for discussions about insolvency-related matters, whether from the creditor, business owner or wherever else.

20:29
Exactly. I’m absolutely happy to help people in this kind of a situation.

Yes, and what not to do as well.

Exactly.

Fantastic. Well, thanks again, Demian.

Thanks, Andrew.