Back From The Brink

The federal government’s new insolvency laws provides a welcome reprieve for small businesses on the brink of bankruptcy but insolvencies are likely to surge once economic conditions return to normal. By Caroline Di Russo.

In late March, the federal government announced temporary changes to insolvency laws amongst a throng of measures aimed at safe-guarding Australians and Australian business during the COVID-19 induced shutdown. In August, these provisions were extended until the end of 2020.

In relation to statutory demands, the existing legislation allows a creditor to issue a company with a statutory demand for payment of a debt of at least $2000 and that company is deemed to be insolvent if they don’t pay the amount within 21 days. Once deemed insolvent, the creditor can apply to the court to have that company wound up. The government’s temporary measures lift the threshold from $2000 to $20,000 and the payment grace period from 21 days to 6 months.

Consequently, and despite the economic turmoil of 2020, there has been a sharp decline in insolvencies compared to last 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 related restrictions and economic uncertainty impacting trading conditions.

The irresistible conclusion is that once the notice period reverts back to 21 days, there will likely be a deluge of insolvencies. The ‘usual’ level of insolvencies we have thus far avoided, together with businesses suffering as a result of government restrictions, has created an artificially large bank of zombie companies. And while borders remain closed and the economy stifled, many companies simply won’t be able to generate sufficient revenue to trade out of their current illiquid positions. Put simply, short term economic conditions will not allow companies to save themselves.

Moreover, a director breaches his duty to the company if he allows the company to trade while insolvent. This provision is designed to protect third parties by placing an onus on directors to put a company into voluntary administration if it is unable to pay its debts as and when they fall due. The temporary measures have put a moratorium on this duty such that directors will not be prosecuted if they continue to trade while insolvent during this period. Unfortunately, this means a business can continue to run up debts with multiple suppliers, without consequence, despite the director potentially knowing the business is, and will be, unable to pay those debts.  

The consequences of this will bear out once the temporary measures are eventually lifted, particularly given the enduring nature of this economic uncertainty. It is unlikely that many distressed companies will regain sufficient cashflow to repay debts: whether those debts be ongoing or whether they have been piling up for months.  The flow on effect is that the creditors of these companies are not being paid, and in this climate, that can very easily impact the cashflow and solvency of those other businesses. Those creditors may then also struggle to repay their own creditors. As cashflow dries up in the business sector so does trust between suppliers.

Recently, the federal government announced its proposed small business restructuring and simplified liquidation process. It’s similar to the Chapter 11 bankruptcy process in the US 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 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 burden in order to leave more value for employees, creditors and shareholders.

I welcome the introduction of this process. Small business has long needed a bespoke restructuring and liquidation procedure. The existing process is a costly and cumbersome exercise for small business and often leaves little or no value for stakeholders at the other end.

That said, I query how many businesses will immediately qualify to rely on these provisions; it isn’t the panacea it is being reported to be in the media. To qualify, the company must have less than $1m in debts, be up to date with employee entitlements and have lodged any outstanding tax returns. Often the hallmark of a failing company is financial disorganisation and outstanding obligations to employees and the ATO.

It is likely that the process will work better in less volatile economic circumstances as businesses will be better able to plan for a potential restructure. However, the brutal nature of the current downturn will likely affect the ability for small businesses to qualify under these provisions given that cashflows have already dissipated and they have not had sufficient opportunity to maneuver into a position to restructure. 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 these economic conditions.

The take up of this new process (if it is passed into law) and the surge of insolvencies once the temporary measures are lifted remains to be seen. Given the lag in economic indicators, we may not see the true extent of this play out until the beginning or middle of next year.

Caroline Di Russo is a lawyer who specialises in commercial disputes, corporate insolvency and reconstruction. 

Watch Nick Cater’s Watercooler interview with Caroline Di Russo on the COVID insolvency crisis and WA border closures.