A sensible winding up of a failed construction company

Table of contens:

Executive Summary

Client background and business

Jim and John were good friends before they went into business together.

Jim was a plumber with 25 years of experience and for the last decade he had specialised in large plumbing jobs for mid-sized builders and property developers. 

John was a carpenter and builder. Before teaming up with Jim, he was the general manager of a mid-sized builder and, after over 20 years of experience in commercial building, he decided to go into business for himself.

Jim started his commercial plumbing business in 2011 and he was joined in 2016 by John. The lads decided to go into business together and combine their plumbing and building expertise to provide a complete construction offering to local councils and commercial developers in Melbourne. 

When they engaged Sewell & Kettle Lawyers, they had about 22 staff and their annual turnover was projected to be around $6m. Unfortunately, the profitability of the business was insufficient to support both Jim and John. Like many building companies they had low profit margins and poor cash flow.

Poor business strategy leads to insolvency

It turned out that our client’s idea to combine building and plumbing into the one business was a poor strategy. It was a poor strategy because on the plumbing side most of the work that Jim brought in was referred by other commercial builders, who liked the idea of engaging specialist plumbers. This meant that by combining with John and offering building as well as plumbing services they cut off many of their key referral relationships and made business development difficult. 

The second problem with their strategy was that they undercharged their services. They priced their jobs aggressively to break into the commercial building market and this resulted in very tight profit margins. For example, their rate for the purposes of job pricing estimates was about $70/hour for plumbers whilst they were paying them $40/hour plus oncosts. 

When they started to consider winding up the business, they realised that they had signed personal guarantees to some key suppliers and that they would become personally liable for those creditors. They were also worried about what other claims they would be personally liable for such as insolvent trading. 

The symptom of potential insolvency that they faced was that cash flow was becoming very tight and this meant that they didn’t have enough cash to fund new projects. The cause of their potential insolvency was related to the profitability of the projects they had undertaken and their poor marketing strategy. 

Personal challenges faced by directors

Jim and John were both, unfortunately, in the processes of getting divorced from their wives. This meant that the lads were not getting any solace at home whilst also getting hammered at work due to cash flow problems.

Both Jim and John had lost the desire to work on the business because they saw it as a lost cause. They realised that their strategic mistake was combining a plumbing and building company and decided that they each needed to go their separate ways and start again. 

Sewell & Kettle Lawyers engaged to give pre-appointment advice due to prior bad experience with voluntary administration

In his previous role, John watched one of his employers put his construction company into voluntary administration and the personal hardship that the voluntary administration process caused to his boss. The process was brutal and after the voluntary administration failed to achieve a settlement with creditors, the company was placed into liquidation and the entire business was lost. 

John’s boss was sued by the liquidator for the recovery of pre-appointment transactions and, as a result of the fallout from the voluntary administration, his boss was pushed into personal bankruptcy. John realised that while the voluntary administrator has an important job to do, they were going to be working for the creditors and that he wanted excellent legal representation to help him prepare for liquidation and shepherd him through the process.

When we were engaged, we had a meeting with the lads and their bookkeeper. At the start of the meeting, the bookkeeper started shaking and then she broke down in tears. She could see the ‘writing on the wall’ and she was scared that she had some responsibility for the failure of the business. It was clear she didn’t bear responsibility, but she was out of her depth and the lads didn’t have a bookkeeper who could help them with working out the profitability of projects. The software systems that the bookkeeper had were insufficient for analysis – Xero (at that time) didn’t have the right analytical tools. 

On the other hand, it became clear to us that the lads didn’t take advantage of the situation and try to take cash out of the company. All the available funds were used to pay suppliers and employees. They hadn’t paid themselves their wages for the last 6 months or taken any drawings that were commensurate with their work contribution. If this were anyone other than the business owner, they would have been accused of committing ‘wage theft’!

The basic financial information for the business showed that it was in a poor condition. The firm’s budget for FY2018 showed that they weren’t confident and they didn’t have proper financial controls. Their budget only allowed a 2% profit margin and therefore it wouldn’t take much of a downside swing for the business to go into the red. 

Key budget metrics for FY2018:

• Income: $5.8m
• Cost of sales: $4.9m
• Overhead expenses: $860k
• Profit: $128k
• Profit margin: 2%

Unlike many other construction company liquidations, the debt owed to the tax office was relatively low because they had mostly kept their tax obligations paid. The tax debt owing at the date of our engagement was $116k and their decision to fold before this escalated showed that they were making a sensible decision at an early stage of the company’s financial distress. 

The financial statements (actuals) recorded the deterioration of the company from a modest profit ($135,821 or 5% of turnover) to a significant loss (-$319,643 or 10% of turnover). 

	FY15	FY16	FY17	FY18
Income	2,702,311	1,231,116	1,972,714	2,962,599
COS	(2,048,145)	(978,583)	(1,436,852)	(2,741,518)
Expense	(518,346)	(332,140)	(539,730)	(514,867)
Profit	135,821	(8,956)	(3,868)	(319,643)

The continuing trade losses contributed to the deterioration of the company’s working capital position and this resulted in the cash flow crisis that the lads spoke to our firm about. It was clear that they had to contribute more working capital quickly and then look at their restructuring options if they wanted to save the company. 

The liquidity ratio is the best measure of company solvency. A liquidity ratio is a type of financial ratio used to determine a company’s ability to pay its short-term debt obligations. The metric helps determine if a company can use its current, or liquid, assets to cover its current liabilities. If the liquidity ratio is significantly less than 1, this indicates that the company needs more working capital to meet its short-term liabilities.

Financial analysis of the company’s liquidity ratio showed that it had sufficient working capital at the end of FY2015. But this deteriorated after that to the point where further working capital was required to fund the business at the end of FY2018. At first blush, the lads needed to contribute up to $400,000, depending on whether they could negotiate instalment plans with creditors. 

	FY15	FY16	FY17	FY18
Current Assets	557,029	265,756	569,062	557,740
Current Liabilities	531,562	382,861	562,391	909,696
Ratio	1:1	0.7:1	1:1	0.6:1

What were the results of our review and what action was taken? 

It was possible for the lads to have turned around the business with cash flow management, negotiation with creditors and hard work. However, it was more likely that they would have had to have undertaken a pre-pack insolvency arrangement or a voluntary administration to obtain a significant debt restructure. They may not have had enough time to use an informal process (such as relying upon the safe harbour from insolvent trading) without first topping up the company bank account from their own pockets. A sensible first step would have been to negotiate a payment plan with the ATO and other creditors to obtain an extension of payment terms to avoid the company tipping into actual insolvency. 

But the lads weren’t looking to restructure because they had already concluded that their business model (of combining a commercial plumber and builder) was poor. John wanted to get back to work as employee general manager and Jim wanted to move on to provide commercial plumbing services with less employees. Therefore, our brief was to help the lads prepare for a winding up of the business. There was no appetite to keep ‘throwing good money after bad’.

It wouldn’t have been optimal for the lads to just terminate all their contracts and put the company into liquidation. For one thing, they had provided personal guarantees for about a third of all liabilities. They also didn’t have enough money at the bank to pay back all creditors in full, so decisions had to be made about how to deal with the cash at bank.   

After we completed an analysis, the following creditors were paid out in priority to reduce the risk to the lads: employee superannuation and suppliers with personal guarantees. After these payments, we recommended that the lads pay themselves their outstanding wages. These wages were recorded in the payroll software but not paid and we advised them that there was a small risk that a liquidator may challenge the payment, but on balance, given the modesty of their base wages (i.e. about $80,000/annum), we didn’t think there was a strong argument that these payments could be found to be unreasonable director-related transactions. Unreasonable director-related transactions involve payments (or other dispositions of property) made by a company to a director, a ‘close associate’ of a director or to a person on behalf of, or for the benefit of, a director or close associate that a Court finds were unreasonable. 

The end result of our review was that the lads were confident about paying monies to creditors strategically and also paying themselves their wages. There’s nothing illegal in that, but a sensible company director will make sure that they aren’t breaking any corporate law before they make payments from the company bank account at the 11^th hour before a liquidation.

The day before the winding up we completed our work and also made sure that the company accounts were reconciled by the company bookkeeper. We documented key resolutions of the board to ensure that the decision to wind up was based on an event of actual insolvency occurring on the date of appointment. All company liquidators (of insolvent liquidations) investigate insolvency and they aim to set a date in their creditor’s reports so company directors should seek professional advice about when their company was actually insolvent. Our view was that it was arguable that actual insolvency only occurred when the directors withdrew personal support for the company. Whilst they were open to contributing monies the company was arguably solvent. After a liquidation is initiated, directors also need to disclose in their ROCAP the causes of insolvency and attend upon the liquidator in the future to explain the company’s circumstances generally. 

The supporting documentation that we prepared is not disclosed as part of this case study, however, to summarise, below are the final board resolutions made before the company was wound up: 

Final board resolutions made on the day before winding up:

• The directors have decided not to advance further monies (from personal resources) to support operations as of 30January 2018 and therefore the continued trading of the businessisnolongerfeasiblebecausefurtheradvancesofworkingcapitalarenecessaryto ensure continuity. The directors’ view is that the company should be wound up on the basis of insolvency. 
• Alloperations ofthecompany areto ceaseon31January 2018dueto the directors’ decision toceasetrading andthe appointment of a liquidator was considered and approved. The proposedliquidator hasbeenaskedtoattendtheprincipalplaceof business toaccepttheappointment andtakepossession of theCompany’s property on31January 2018.
• The directors have approved final payments to be made today to creditors and the Company’s proposed liquidator. After these payments are made the bank balance will be close to nil and the directors are to close the overdraft account as soon as possible.

When the final resolutions were signed and the bank account payment made, none of the employees or suppliers were aware that the company would be wound up. The day of the liquidation was going to be a difficult day, not only for the lads, but also for their employees (and their families) and subcontractors/suppliers.

Our view was that, from a professional perspective, at least, the lads’ situation was tidy immediately before the wound up commenced. Our clients, in our view, had done everything they could to minimise the risk of being sued by a liquidator or third party and they had properly attended to pre-liquidation matters. 

Appointment of a sensible and commercial liquidator

The liquidation profession, over the course of its history, has had a lot of bad apples. The last thing any director wants is an unethical liquidator to be appointed to their company – it could become a nightmare for them. The reason for this is that unethical liquidators run ‘bait and switch’ strategies to attract work from company directors. They have a confidential meeting with company directors where they promise that they won’t take action to sue the directors for insolvent trading or voidable transactions (i.e. the bait). Then, after they are appointed, they nevertheless start taking legal action against the directors (i.e. the switch) with the objective of supersizing their fees. 

The better approach is to get pre-liquidation advice from an insolvency lawyer and then appoint a sensible and commercial liquidator afterwards once risk areas for the directors have been identified (i.e. due diligence). If there are any issues, the insolvency lawyer should pick them up in advance and, unlike a public accountant, any advice is privileged and confidential. The liquidator isn’t put under a conflict of interest by being asked to provide pre-appointment assurances of any type when an insolvency lawyer is appointed in advance.

A sensible and commercial liquidator should act in the interests of creditors and make efficient decisions rather than take actions that are intended to supersize their fees without any meaningful return to creditors. The overwhelming majority of liquidations produce no returns to creditors and the directors of the company also haven’t done anything wrong. Therefore, most of the time, insolvent liquidations should be relatively straightforward for the liquidators to execute. It’s a pity that liquidators don’t charge based upon the value of assets recoveries and that they charge hourly fees because hourly billing only supports the incompetent and unethical. One of our roles is to help the client select an appropriate liquidator and ensure that they receive all the documents and information they need to efficiently complete their job. 

We were on site to help the directors on the day the liquidator was appointed and we helped them deal with the liquidator and undertake preliminary calls to creditors and to terminate the employees. 

Report written, debts collected and liquidation closed

One key deliverable of company directors is to provide estimates of realisable assets to the liquidator. The documents we helped the directors to provide showed that once the directors had withdrawn their financial support and their personal labour (intangibles), the realisable assets of the company were small:

• Debtors and cash retentions: $237k*
• Stock: $10k
• WIP: $0
• Plant and equipment: $10k
• Other assets: $30k
• Total director’s estimate of realisable assets: $287k

*In construction liquidations, the face value of debtor and cash retention claims often get reduced to a zero realisation value because head contractors and developers make set-off claims claims and inflate the costs of incoming contractors to avoid payouts to liquidators.

The reality is that once you take the lads out of the business equation, you end up with a warehouse full of pipes and odd building supplies, vehicles that are subject to hire purchase agreements and progress claim invoices. There is going to be no goodwill left in the business. Unfortunately, construction progress claims and cash retentions are difficult to get out of developers unless the documentation is in order and the directors provide a complete account of how the project transpired to a liquidator.

The fact that small-to-medium sized business liquidations end up with few realisable assets is the nature of the beast. Because the lads called in the liquidators relatively early the total liabilities of the company weren’t anywhere near as high as it would have been had they persisted for another 6 months. The total creditors owing at the date of liquidation was approximately $606k.

In all insolvent liquidations the liquidator must investigate the company’s financial affairs and report to creditors about what they find. In most creditor’s reports the liquidator will write up a preliminary analysis of insolvent trading and put their general opinion to creditors. Liquidators don’t usually run insolvent trading claims against directors and this is for a variety of reasons. Set out below is an excerpt from the liquidator’s (publicly available) report to creditors in this liquidation about the conclusions of his investigations:

Conclusion

Accordingly, creditors should note:

• The successful pursuit of an insolvent trading claim would be subject to the availability of further information to support litigation, the possibility of an action being defended, and the length of time in having the matter listed and the considered by the court;
• The ultimate recovery of funds for the benefit of creditors would be subject to costs of litigation and winding up; 
• Any action taken in regard to an insolvent trading will be vigorously defended; 
• The Director will need to have adequate cash resources to satisfy the claim. However, at this point in time, it appears that the Director has insufficient cash resources to satisfy claim; 

It is my opinion that an insolvent trading claim pursued by a Liquidator against the Director is unlikely to result in any return to any class of creditor. However, given the identified assets of the holding company there may be a return to creditors should there be recoveries subject to Section 588 of the Act.

Accordingly, there may be an action available against the Directors for the increase in debts incurred from at least 1 July 2016 up to the date of our appointment that remain outstanding. Further investigations in the event of Liquidation may identify an earlier date of insolvency.

Based on creditor claims in the Liquidation to date, it appears that the quantum of an insolvent trading claim would be in excess of approximately $403,116.

Notwithstanding the above, creditors should consider the ability of the Directors to repay a judgment order against him should the Liquidator be successful with an action. 

The analysis is somewhat cryptic, but non-action for insolvent trading is the norm in the liquidation industry. We disagree with the liquidator’s findings about the date of insolvency but it’s really a moot point. It’s very likely that the liquidator never seriously considered an insolvent trading claim because he didn’t actually have a valid claim to pursue in the first place as the lads called in the liquidators relatively early. 

It did help the lads to have a specialist insolvency lawyer to consult with about insolvent trading allegations and act as the director’s representative in dealings with the liquidator generally. After the liquidator reported to creditors, he undertook work to recover some debts and then essentially closed down the matter. 

Takeaways

• Most insolvent liquidations don’t result in any return for creditors so there is nothing out of the ordinary that this occurred here.
• If directors don’t perform some due diligence before commencing a liquidation, they put themselves at risk of liquidator action.
• Directors should be careful about what transactions they undertake before a liquidation commences, but they should also look to act strategically to minimise the fallout from the liquidation process.
• Directors would usually benefit from advice regarding insolvent trading – at least to understand it and develop a strategy about it before any liquidation commences.
• Directors should look to engage a sensible and commercial liquidator rather than a liquidator that offers empty assurances before their appointment – it is better to go through an insolvency lawyer to prepare for liquidation and select an appointee who they have had positive experiences with.

*The company is now deregistered and the liquidation process concluded in 2021. The clients gave our firm permission to draft this case note once the liquidation was completed.