How NOT to do a Pre-Pack Insolvency Arrangement: Bad Pre-Insolvency Advice
A recent Victorian Supreme Court case, Intellicomms, shows the dangers of poor pre-insolvency advice and entering into a pre-pack without carrying out sensible due diligence. Here we explain the implications of this case for directors, the appropriate valuation approach to avoid liquidator claims for creditor-defeating dispositions, and what all this means for pre-packs in general.
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Pre-packaged insolvency arrangements (commonly known as ‘pre packs’ or ‘pre-packs’) are a restructuring option in Australia for businesses that are insolvent, where those businesses carefully follow the requirements set out in the Corporations Act 2001 (Cth). This includes meeting the requirements aimed at punishing/preventing illegal phoenix activity.
Here we look at the recent case of Re Intellicomms Pty Ltd (in liq)  VSC 228 (‘Intellicomms’) which considers the circumstances under which an asset sale will constitute a ‘creditor-defeating disposition’. Arguably, this case shows the risk to directors in following poor pre-insolvency advice.
What are the requirements for a pre-pack?
In a pre-pack, the assets of the distressed company are sold to a new company — which the original directors control — and the original company is then liquidated. The net effect is that the business can go on to trade with business assets in hand, without pressure from prior creditors.
Directors preparing a pre-pack can avoid liability for allowing insolvent trading by availing themselves of the ‘safe harbour’ under section 588GA of the Corporations Act 2001 (Cth).
Under this provision, a director is not liable while they are developing a plan of action that is ‘reasonably likely to lead to a better outcome for the company’ than an immediate liquidation.
Those preparing a pre-pack need to tread carefully in order to avoid illegal phoenix activity. This is operationalised through the Corporation Act prohibition on creditor-defeating dispositions. In short, this means that directors are prohibited from transferring assets to a third party for less than market value within 12 months of an insolvent liquidation starting. If a liquidator finds that this has occurred, they can claw-back the transaction in question, and initiate criminal or civil actions against directors for facilitating the disposition.
In Intellicomms, the Court found that a director had engaged in phoenix activity by selling assets to a third party at a sufficiently low price and that those transactions were creditor-defeating dispositions (more on this case below). Decisive in the Court’s reasoning was the fact that one of the creditors was willing to pay a much higher price for the business ($500,000 plus), than the price agreed to in the pre-pack ($20,000).
How can a pre-pack go wrong? The Intellicomms case.
After the winding up of the original company, the liquidator must investigate any potential wrongdoing of directors. This includes looking into potential recovery actions. These actions include claims for unfair preferences, uncommercial transactions, unreasonable director-related transactions and creditor-defeating dispositions. In some cases, a large creditor who feels they have been disadvantaged by a pre-pack will fund this claim and subsequent litigation.
The key is the valuation approach. Generally speaking, a pre-pack will involve a ‘fire sale’ price, rather than the valuation approach used by healthy businesses — ‘multiples of maintainable earnings’. Crucially, directors undertaking pre-packs need to be prepared to make their case for the valuation in court, in order to avoid the prospect of phoenix activity allegations.
So some level of due diligence is required by directors before signing up to a pre-pack. But how much, exactly? Directors must undertake an evidence-based assessment of risk — any liquidator examination of phoenix activity will be evidence-based (i.e. it is not anyone’s subjective intentions or desire to be ‘clever’ that is relevant).
In Intellicomms, a series of valuation reports were gathered by the director, and these showed a goodwill value for the business. That is, the business had value over and above the price of its tangible assets. This should have been the first indicator that the business had significant value, and that a fire sale was inappropriate. A pre-pack would usually be more appropriate where the business is consistently making a loss (hence the insolvency), so attempting to pre-pack at fire sale prices in these circumstances may be wading into phoenix territory (i.e. asset stripping).
It is possible that Intellicomms was never really about insolvency in the first place, but about corporate control. A related party creditor with significant equity in the business (QPC) got cut out by the pre-pack. A pre-pack is not an appropriate instrument for such a purpose and in this case the corporate control dispute played out through litigation.
In Intellicomms, it appears that thorough due diligence was not undertaken. It also appears that directors were not forthcoming to the liquidator, as the liquidator took legal action very soon after appointment to reverse the pre-pack transaction.
All in all, this indicates that, perhaps, the pre-insolvency advisers did not properly consider the risk this pre-pack posed to the director and advise accordingly.
Besides general questions about the valuation, in Intellicomms there is also the more specific question about how difficult the valuation of intellectual property in software might be. In light of this, it may not be a good idea to transfer it in a pre-pack. Instead, it may be more sensible to licence it in order to avoid a phoenix allegation, then a final price can be negotiated with the liquidator afterwards.
When will a transfer of assets be a creditor-defeating disposition?
Under the Corporations Act 2001 (Cth), a transaction defeats a creditor of what they would be entitled to on liquidation where a transaction for consideration meets the lesser price prescribed in two limbs – the consideration is less than either (a) market price or (b) the best price reasonably attainable.
In Intellicomms, the Court found it relevant that a creditor (QPC) was willing to pay a lot more for the assets than the final price in the pre-pack sales agreement. The Judge also took into account:
- There was no explanation as to why there was a sale of assets prior to liquidation.
- The director appeared to be shopping for the most pessimistic valuation. An $11 million value in June 2020 had become a value of $57,000 by the final valuation in September 2021. Furthermore, these reports should have made the director aware that it was inappropriate to apply a fire sale asset price in this situation (as there was significant goodwill in the business).
- The sale was not exposed to the open market. If it had been, it is likely that a much higher price would have been received.
- Voluntary administration was not even considered for the business (source).
What does this mean for pre-packs?
Frustratingly, perhaps, ‘market price’ is still not defined in Intellicomms, which puts pre-packs in a degree of danger. In essence, the onus is on the director to be able to demonstrate that the price was the market price or the best price reasonably attainable. It is also worth noting that the Court found that a ‘correct’ price for the sale does not need to be ascertained in order to find that there was a creditor-defeating disposition.
A good general rule of thumb is that it is not advisable to use pre-packs, except where there is genuine insolvency and a fire sale valuation of assets is arguable in Court. Furthermore, pre-packs should only be prepared in cases of genuine insolvency — it is not sensible to use them simply as a mechanism for seizing corporate control.