Why Aren’t Pre-Pack Insolvencies More Common in Australia?

Background 

Pre-pack insolvency is the sale of a business and its assets prior to the appointment of an insolvency practitioner, often to the related parties (i.e. existing directors or shareholders). For this reason, pre-pack insolvencies are not looked upon favourably in Australia when compared to our UK counterparts. In this regard, approximately 63% of all pre-pack administrations in the UK are completed by related-parties.

Australian Landscape

In Australia, there has been a long-running crackdown by ASIC and the ATO in relaiton to illegal pheonix activity, which is essentially a sale or transfer of business for little or no value with the intention of defeating creditors (i.e. employee entitlements, statutory debts and unsecured creditors). However, it is important to make the distinction between illegal pheonix activity and pre-pack insolvency. ASIC provides guidance that the key difference between a legitimate restructure via pre-pack insolvency and illegal pheonix activity is “the director’s dishonest intentions or recklessness”. Accordingly, ASIC has determined that pre-pack insolvency is a legitimate tool for director’s to restructure their business provided the assets are independently valued, and a true market value is paid for the assets. In theory, this provides a better return for creditors in comparison to a sale by an Administrator or Liquidator under the insolvency regime.  

International Landscape

Debtor-led restructuring is commonplace in many jurisdictions:

1. United Kingdom – pre-pack administrations are used to ensure a debtor’s business continues as a going concern, and accounts for approximately 29% of all Administrations. 

2. United States – under Chapter 11 bankruptcy proceedings, the debtor company retains control of its own resctructuring allowing it to undertake a sale of the business or otherwise develop a restructuring plan. 

3. Canada – under the Companies’ Creditors Arrangement Act (CCAA), the debtor company also retains controls of its own restructuring allowing it to undertake a sale of the business or otherwise implement a plan of arrangement.

Both US and Canadian insolvency regimes are prodominantly court-driven processes which do not allow for direct comparison with Australia. Conversely, the UK insolvency regime is similar to the insolvency regime in Australia. UK insolvency practitioners widely accept that pre-pack administrations can often provide creditors with a better outcome in comparison to a sale under administration. However, recent discourse and regulation in the UK has shown there are some key elements that need to be assessesed by the insolvency practitioner, including; independent business valuations, and the ongoing viability of the underlying business. 

Pre Pack Insolvency Process 

Generally, the pre-pack insolvency process will follow the below steps:

1. Assessment – review of company and underlying business, presenting director’s with options for restructuring, including; safe harbour protections, pre-pack insolvency, voluntary administration, liquidation. 

2. Planning & Preparation – once the decision is made to execute a pre-pack insolvency, the directors will need to have the business and assets independently valued and any sale of the business or assets should be based on this valuation. Legal and transaction advice should be obtained to ensure operational, commercial and legal risks are mitigated. 

3. Execution – a sale contract is prepared, and the sale of business or assets executed and transferred to a new entity. Employees will ordinarily be transferred to the new entity which accepts liability for accrued entitlements. 

4. Completion – a Voluntary Administrator or Liquidator is appointed to the old entity, and purchase price consideration is paid to the old entity subject to insolvency proceedings. The insolvency practitioner will undertake its own investigations into the pre-pack sale and ratify the sale contract as appropriate. 

In all pre-pack insolvency transactions, it is prudent for the directors to engage external professionals in the areas of valuation/transaction advice, legal advice and subsequently an Insolvency practitioner. In Australia, the valuation/transaction advisor cannot be the same as the Insolvency practitioner due to conflict of interest (as explained below). 

Advantages 

• Preservation of value and jobs – a sale as a “going concern” ensures that there are limited interruptions to continuing business operations. Employees and their entitlements are commonly transferred to the new entity. Typically, a sale at market value will provide a better outcome when compared to a piecemeal liquidation of assets by an Insolvency practitioner. 

• Business continuity – the business will continue to trade under a new corporate structure which protects its image, brand and limits adverse publicity. From a legal perspective, ipso facto clauses in commercial contracts may significantly depress the valuation of the business if it were to enter into external administration prior to a sale. 

• Speed of restructure – pre-pack business sales can be performed relatively quickly in comparison to a sale of business under external administration. A pre-pack sale can be performed in a matter of days, as compared to 4-6 weeks for a sale or restructure of a business subject to external administration. 

• Lower restructuring costs – pre-pack business sales are generally cheaper than the trade-on and sale of a business by an Insolvency practitioner. These types of Voluntary Administrations are usually a costly exercise and present uncertainties for directors wishing to maintain control of their business. In some circumstances, insolvency practitioners may not be in a position to continue trading a business under their control, which further depresses the value of the underlying business assets. 

• Operational improvements – pre-pack business sales are essentially providing the directors with a “clean slate” to carry on their business in a new corporate structure. This can be a positive inflection point for the directors to implement financial and operational improvements in the business to mitigate the risks of future business failures. 

Disadvantages 

• Under-value transfer – businesses or assets that are transferred for less than market value may be deemed illegal pheonix activity by the Insolvency practitioner, the Courts or ASIC. If the Court or the Insolvency practitioner determine that the transaction amounts to an uncommercial transaction, an unreasonable director-related transaction or a creditor-defeating disposition, then the sale agreement may be unwound and the directors may be held liable for any loss suffered. 

• Lack of transparency – creditors (particularly unsecured creditors) are not consulted in the pre-pack sale process. This can leave unsecured creditors feeling disenfranchised or ripped-off by the process, and create signficant obstacles for the directors continuing to trade the business in a new entity with the same suppliers who may be left out of pocket with the insolvency of the old entity. 

• Lack of regulation – the pre-pack insolvency market is largely unregulated, so directors need to be wary of advisors who seek to provide advice in relation to illegal pheonix activity. Ultimately, the directors and Insolvency Practitoners will be required to exercise their duties as defined in the Corporations Act 2001 (Cth). 

• Conflict of interest – the insolvency regime, and particularly the independence provisions for insolvency practitioners prohibit them from providing advice to a company they are subsequently appointed to act for in an insolvency proceeding due to a conflict of interest. This is logical given the Insolvency practitioner cannot be impartial when asked to review a transaction in which he/she has already provided advice to the insolvent company. This means an Insolvency practitioner can provide pre-pack insolvency advice, or act as the Administrator/Liquidator, but not both. 

• Secured creditors – in certain circumstances, secured creditors may be owed more than the market value of the business. A secured creditor with a charge over the assets of the business would need to consent to releasing its charge. In these cases, a secured creditor may be able to appoint a Receiver to the assets of the business which would likely void any pre-pack business sale. 

Key Success Factors 

1. Independent valuation advice – it is a director’s duty to act in the best interests of a company, and the company’s creditors. By obtaining independent valuation advice and ensuring they pay a market value for the business or assets being transferred, it is fair to assume the director has acted in the best interests of the company and its creditors. 

2. Legal advice – while the pre-pack process is relatively straightforward, not every business is created equally. By obtaining specialist legal advice, the directors become comfortable that their course of action is in the best interests of creditors, that they have exercised and discharged their director’s duties, any other legal considerations effecting business continuity have been considered. 

3. Best interests of creditors – in order for a pre-pack insolvency to be confirmed and ratified by an Insolvency practitioner, it has to provide a better outcome to creditors than a sale under external administration. Generally, this is an exercise that should be performed by the directors and their advisors prior to undertaking a pre-pack sale of business.  

4. Market value – ensuring a market value is paid for the business assets will significalty reduce the downside risks associated with a pre-pack insolvency. When paying a market value, it is assumed that the directors are not engaging in illegal pheonix activity. Furthermore, paying a market value will assist with the insolvency practitioner’s completion and ratification of the pre-pack sale in a timely manner. 

Conclusions 

The pre-pack insolvency process provides a legitimate and legal means for distressed companies to restructure their affairs. In Australia, the process is not widely used or accepted when compared to the UK insolvency regime. Recent ASIC and ATO crackdowns on illegal pheonix activity has potentially scared many would-be proponents of the pre-pack insolvency. 

As discussed above, director’s can find comfort in the pre-pack insolvency process by exercising and discharging their director’s duties, obtaining independent valuation and legal advice, ensuring market value is paid, and securing a sale that is in the best interests of creditors. 

If the directors of an insolvent company execute a pre-pack insolvency at market value, maintain employee entitlements and ensure that creditors are no worse off than an orderly liquidation of the company’s assets, then why is this approach not used more often in Australia? 

With the debt load of many SME businesses increasing signficantly since the COVID-19 pandemic, the stage is set for an uptick in pre-pack insolvencies as a legitimate means to restructure a distressed business.  

Groves & Partners are expert business restructuring advisors and valuers, with significant experience in valuing businesses and companies for restructuring purposes. If you believe you may require a valuation for your proposed restructure and would like to know more about how we can work with you, contact us on 1300 892 717 (+61 2 7208 7970) or email info@groves.com.au.