by Paul Fury

In August 2018, the Federal Government released for public comment draft legislation aimed at combating illegal phoenixing activity. However, even if enacted, it is questionable if the proposed legislation will have a great deal of effect.

A longstanding difficulty with illegal phoenixing is that the term is not defined either in the Corporations Act or by case law. However, it is broadly understood to mean the transfer of the assets of an insolvent company to a new entity with the company being left as just an indebted shell.

The draft legislation does not address this definition issue. Instead, it introduces in proposed section 588FDB of the Corporations Act the new concept of a “creditor-defeating disposition”. This term is central to the proposed legislation.

A creditor-defeating disposition is defined to mean a disposition of company property that has the effect of preventing, hindering or significantly delaying the property becoming available to meet the demands of the company’s creditors in winding-up.

The definition is clearly derived from section 121 of the Bankruptcy Act which, in turn, was based on provisions such as section 37A of the Conveyancing Act (NSW). Although often overlooked, this latter provision is available to the liquidator of a company.

The definition also has similarities with the present subsection 588FE(5) of the Corporations Act, one element of which is that the company became a party to a transaction for the purpose, or for purposes including the purpose, of defeating, delaying, or interfering with, the rights of any or all of its creditors on a winding up of the company.

However, unlike these other provisions, all of which are concerned with the purpose of the disposition, a creditor-defeating disposition looks to the effect of the disposition.

At first glance, this difference might seem to make it significantly easier to challenge a transfer of property as a creditor-defeating disposition rather than to challenge it under either section 37A or subsection 588FE(5).

However, in a proceeding under section 37A or subsection 588FE(5), the Court will readily infer the requisite purpose if the transfer of property has the necessary consequence of preventing property from becoming available to creditors or of defeating or delaying them.

Consequently, in practice, this proposed shift from looking at the purpose of a transfer to the effect of it is unlikely to make a great deal of difference.

Using this definition of a creditor-defeating disposition, it is proposed in the draft legislation to allow liquidators to have resort to a new type of voidable transaction to challenge transfers of property.

Proposed subsection 588FE(6B) of the Corporations Act provides that a transaction is voidable if:

  • it is a creditor‑defeating disposition of property of the company;
  • at least one of the following applies:
  • the transaction was entered into, or an act was done for the purposes of giving effect to it, when the company was insolvent;
  • the company became insolvent because of the transaction or an act done for the purposes of giving effect to it; or
  • less than 12 months after the transaction or an act done for the purposes of giving effect to it, the start of an external administration (as defined in Schedule 2 of the Corporations Act) of the company occurs as a direct or indirect result of the transaction or act; and
  • the transaction, or the act done for the purpose of giving effect to it, was not entered into, or done under a scheme of arrangement or a deed of company arrangement or by a liquidator or provisional liquidator.

Unless paragraph b(iii) is relied on, there is no temporal limit to the operation of proposed subsection 588FE(6B). However, the dispositions that potentially could attract the operation of the subsection are likely to occur within 18 months or so prior to the commencement of the winding up.

This is because most illegal phoenixing activity at the present time follows upon either the Deputy Commissioner of Taxation taking steps to enforce the payment of an outstanding tax debt by a company or the directors of the company apprehending that he is about to do so. In either case, the result is that the transfer of assets often is followed within a relatively short time by the winding up of the company, either on the application of the Deputy Commissioner or by the directors through the mechanism either of a creditors voluntary winding up or an administration.

Significantly, a disposition of property effected via the mechanism of a deed of company arrangement falls outside the scope of proposed subsection 588FE(6B). Potentially this permits related creditors (creditors who are related entities) and other “friendly” creditors to vote through a deed that involves a disposition of property that would otherwise fall within proposed subsection 588FE(6B) on a winding up of the company.

This exception to the subsection highlights one aspect of the draft legislation which the Government has very recently enacted.

The Insolvency Practice Rules have just been amended to provide that a related creditor who is owed a debt as a result of taking an assignment of that debt from another creditor may only vote for an amount equal to the value of the consideration given for the assignment.

The amendment may be compared with the position that prevails in bankruptcy where, since 1996, any creditor who takes a debt by assignment may only vote for the amount of the consideration paid by them for the debt.

In practice, the buying of debts by related creditors to affect the outcome of a vote is not common as it is an all too obvious means of producing an outcome and, as such, is unlikely to survive a Court challenge. Anecdotally, it seems that it is more common for the directors of a company to enter into undisclosed collateral arrangements with selected arm’s length creditors in exchange for their votes.

Given this, the recent amendment to the Insolvency Practice Rules is unlikely to have much effect upon related creditors and other “friendly” creditors voting through a deed of company arrangement that involves a disposition of property that would otherwise fall within proposed subsection 588FE(6B). In such a case, a creditor who is dissatisfied with the outcome of the vote would still need to make a Court application to set aside the deed.

Assuming though that a liquidator is able to establish that a disposition of property falls within proposed subsection 588FE(6B), the question obviously is raised as to what defences there are to such a claim.

In this regard, it first is proposed that neither subsection 588FG(1) nor subsection 588FG(2) of the Corporations Act, which are the standard defences to other voidable transactions such as unfair preferences or uncommercial transactions, be available as a defence to a claim under subsection 588FE(6B).

Instead, it is intended that there be three new defences, all of which will be specific to subsection 588FE(6B).

The first defence is a safe harbour defence. Section 588GA contains the safe harbour provisions of the Corporations Act. Their full effect is beyond the scope of this article but, broadly speaking, these provisions currently protect directors from liability for debts incurred by an insolvent company in connection with a course of action that is reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator.

Proposed subsection 588FG(8) will extend this protection to a claim under subsection 588FE(6B) if section 588GA would apply to an officer of the company in relation to the disposition.

However, this defence will only be available the if the relevant transaction was entered into when the company was insolvent or the company became insolvent because of the transaction. It will not be available if the company goes into external administration within 12 months of a transaction as a direct or indirect result of the transaction.

The second defence prevents a Court from making an order materially prejudicing a right or interest of a person to whom the disposition of property was made if there is evidence before the Court that consideration was given for the disposition and the value of it was at least the market value of the property at the time of the disposition or at the time any relevant agreement was made for the disposition.

Although not entirely clear from the relevant clause of the draft legislation, it appears that this defence requires the person to whom the disposition was made to adduce evidence that suggests a reasonable possibility of both of these matters and for the Court to then be satisfied that consideration of market value was given.

The third defence prevents a Court from making an order materially prejudicing a right or interest of a person who is not a party to the creditor‑defeating disposition if it is proved that the person later acquired the property in good faith and for consideration whose value was at least the market value of the property when the person acquired it.

The second of these defences is likely to be the most significance and its inclusion in the legislation appears to reveal a fundamental misunderstanding on the part of the Federal Government about how illegal phoenixing normally is conducted.

Generally, the directors of a company do not phoenix its assets by selling them to a new entity for nominal consideration. Rather the sale is made for what is claimed to be market consideration, albeit that cash is not paid to the company.

For instance, the employees of the company may be persuaded to agree to have their employment transferred to the new entity and the value of the entitlements assumed by the new entity then is counted as some or all of the consideration for the transfer of the assets of the company. Similarly, the new entity may agree to pay the amounts owing to some of the trade creditors of the company in consideration of the transfer of the assets of the company.

In practice, this defence to proposed subsection 588FE(6B) is likely to be established far more readily than the Federal Government may imagine.

Given this, liquidators are still likely to rely primarily upon subsections 588FE(3), 588FE(5) and 588FE(6A) to challenge illegal phoenixing activity on the basis that the asset transfer is an uncommercial transaction, a creditor defeating transaction or an unreasonable director related transaction of the company. They also still are likely to allege that the asset transfer involves a breach of the directors’ statutory and fiduciary duties.

The main reason that liquidators don’t challenge illegal phoenixing activity more often at the present time is a lack of funds. Except possibly in one respect, this position isn’t changed by the proposed legislation.

The possible exception arises from proposed section 588FGAA which gives ASIC the power to make an administrative order to recover property the subject of a voidable creditor-defeating disposition. ASIC may use this power either on its own initiative or on the application of the liquidator of a company.

This provision obviously is based on section 139ZQ of the Bankruptcy Act which permits the Official Receiver to give a notice and was added to that Act back in 1992. However, unlike section 139ZQ, which applies to all forms of transactions that are void against the trustee of the estate, proposed section 588FGAA only applies in relation to a voidable creditor-defeating disposition.

An order by ASIC is subject to the same defences as a claim by a liquidator and the recipient of an order may apply to set it aside. What is not clear from the draft legislation is the party who bears the evidentiary onus on such an application. In this regard, it is noteworthy that the Courts have held in relation to an application to set aside a notice given under section 139ZQ of the Bankruptcy Act that the trustee still bears the onus of establishing that the transaction is void against him.

If ASIC is held to bear a similar onus, it is likely that few administrative orders will be made by it. Even if it doesn’t bear such an onus, it is questionable how many such orders will be made by ASIC on the application of liquidators given that the making of such orders may see ASIC potentially involved in major litigation.

As part of the Government’s package, it is proposed to introduce two new offence provisions into the Corporations Act. New section 588GAA make it an offence for a company officer to cause a company to make a creditor-defeating disposition.

The elements of the offence and the defences available largely mirror the elements and defences that apply to making a disposition voidable. Some additional specific elements and defences focus on the conduct of the officer alleged to be responsible for the company making the disposition.

This provision is joined by proposed section 588GAB which prohibits a person from engaging in the conduct of procuring, inciting, inducing or encouraging the making by a company of a creditor-defeating disposition. This provision is principally directed at so-called pre-insolvency advisors.

Given that the great bulk of debt that is affected by phoenixing activity is owed to the Deputy Commissioner of Taxation, the need for these provisions is questionable. If a company has tax debts, the phoenixing of its assets currently can give rise to a charge of conspiracy to defraud the Commonwealth under the Commonwealth Criminal Code. Moreover, the Crimes (Taxation Offences) Act 1980, which originally was enacted in response to the so-called “bottom of the harbour” tax avoidance schemes of the 1970s, also potentially is applicable.

Both of these Acts already permit the charging not only of the company’s directors but also of any pre-insolvency advisor involved in the phoenixing of the company’s assets.

As is the position with the current insolvent trading provision, the two new offences provisions are proposed to be paralleled by civil penalty provisions. In the case of both the civil penalty and the offence provisions, any proceedings will be required to be initiated by ASIC and therein lies the rub.

As the current banking Royal Commission has again underlined, leaving aside summary matters such as prosecuting a director for not providing a liquidator with a Report as to Affairs, the record of ASIC in taking enforcement action for serious breaches of the Corporations Act is less than stellar, particularly in the case of criminal prosecutions. Barring a major cultural change at the corporate regulator, it is hard to see many pre-insolvency advisors losing too much sleep over the prospect of being prosecuted by ASIC under the new provisions.

If the Government is serious about tackling phoenixing activity, it might be better advised to deal with the problem at its root. As previously mentioned, much of debt that is affected by phoenixing activity is owed to the Deputy Commissioner of Taxation. This is due to the fact that the ATO often waits a year or more before starting enforcement action against a delinquent company taxpayer. More vigorous enforcement of company tax payments by the ATO would greatly reduce the problem of phoenixing as the large tax debts wouldn’t arise in the first place.

Similarly, the current taxation secrecy provisions facilitate phoenixing and could be replaced by a regime where company tax debts that are overdue for 60 days or more are automatically reported by the ATO to the registered credit reporting bureaus.

Draft legislation permitted credit reporting actually was circulated earlier this year by the Government but was hedged around with a number of qualifications. The most notable of these preserved secrecy for a taxpayer who was “effectively engaging” with the ATO to manage its tax debt. A taxpayer could do this by entering into a payment plan with ATO or even merely by objecting to its debt.

Given the current state of Federal politics, it is unclear when the Government’s proposed legislation to combat illegal phoenixing activity will become law or even if it will at all. Certainly, there is nothing in the draft legislation to indicate that it will operate retrospectively.

Notwithstanding this, it is clear that the Government currently is focused upon illegal phoenixing activity with no less than three separate taskforces investigating such activity. Moreover, as previously stated, there are presently provisions in both the Corporations Act and the criminal law that permit such activity to be effectively challenged.

In these circumstances, if the directors of a company propose to transfer some or all of the assets of the company in circumstances that could possibly give rise to a contention that they have engaged in illegal phoenixing, they would be well advised to seek professional advice.

Veritas Advisory is able to advise and assist with the lawful restructuring of a company’s assets, including by having resort to the safe harbour provisions of the Corporations Act, and can also assist with the transfer of assets through the mechanism of a deed of company arrangement.

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