Directors shouldn’t expect voluntary administrators to absorb risk
Elon Musk is an entrepreneur and scientist who risked much of his earnings from a successful PayPal venture to fund Tesla and SpaceX. At one point, it was reported that he had put every last cent into Tesla and that he had cashflow problems. Taking a risk on a big future bet is outside of what is possible during a voluntary administration. The procedure is designed to stop future risk-taking by putting companies under the control of accountants who are at personal risk of losing their homes if there is negative business cash flow.
In a voluntary administration, the directors of an insolvent, or soon to be insolvent, company transfer control and oversight of the company to an independent insolvency professional – the voluntary administrator. How do voluntary administrators calibrate the risk of an appointment? And how much risk should directors expect voluntary administrators to take on? We explore the answers to these questions.
Voluntary administrators have personal liability
Voluntary administration is a restructuring mechanism set out in the Corporations Act 2001 (Cth) whereby an independent insolvency professional is appointed to a distressed company with the goal of ‘turning the business around’. In theory, the voluntary administrator strives to come to a compromise with creditors, a ‘Deed of Company Arrangement’ or ‘DOCA’, allowing the company to eventually return to the control of directors, and go on trading unencumbered by debt.
In reality, most voluntary administrations end up with the company being liquidated (read more at How to avoid a voluntary administration of your company (for small or medium-sized enterprises).
The appointment is made by directors. After resolving that the company is insolvent, or likely to become insolvent, with the consent of a prospective voluntary administrator, they can initiate the process. On appointment, the voluntary administrator takes on all responsibilities of the company and becomes an officer of that company.
Crucially, the voluntary administrator also becomes liable for any debts that they incur in the performance of that role. Under section 443A of the Corporations Act 2001 (Cth), the voluntary administrator is liable for debts incurred relating to:
- services rendered;
- goods bought;
- property hired, leased, used or occupied;
- repayment of borrowed money (including interest); and,
- any borrowing costs.
Furthermore, under subsection (2) of that section, the voluntary administrator cannot contract out of this liability.
As can be seen from this section, the liability of the voluntary administrator for the performance of the company is even greater than the liability of directors. For example, if a voluntary administrator turns cash flow negative under their watch, they are personally liable for that negative trading. Voluntary administrators aren’t protected by the corporate veil and it is a deliberate policy that has the effect of scaring them from taking any risk.
In order to place limits around their liability, as part of their appointment, voluntary administrators indemnify themselves through a lien on company property. But the value of this lien is limited to the value of assets or future cash flows of the business and any sensible voluntary administrator will take a very conservative view about asset values and potential future cash flows for a business.
What are the consequences of a voluntary administrator’s extensive personal liability?
Before voluntary administration is commenced there is a ‘beauty parade’ of potential appointees. Voluntary administrators are strictly required to limit their discussions to talking about ‘insolvency options’, but sometimes the potential appointees make commitments to secure the appointment. The key take-away for directors is that a commitment to continue to trade is not going to be met if it puts the voluntary administrator at personal risk of financial loss.
As the voluntary administrator acquires complete control of the company on appointment, it is their decision whether to continue trading, or to focus their efforts entirely on other aspects of the role (such as preparing the DOCA). The directors don’t have any legal right to intervene in a decision to cease trading a business in voluntary administration and it is extremely unlikely that they would be able to persuade a court to second-guess a commercial decision of a voluntary administrator. The directors would need to contribute working capital to fund the voluntary administrator process to save it from closure in that circumstance. Any funding advance, however, would defeat the purpose of the voluntary administration because the objective of the process is to obtain a ‘debt haircut’ via a DOCA, not further expose the directors to personally paying for short-term losses.
A key consequence of the extensive scope of personal liability that a voluntary administrator incurs in their role is that they are less likely to continue trading while in control of the company. After all, continuing to trade is an option for voluntary administrators, but it is not an obligation.
It should be pointed out that, in addition to the personal liability for debt, the voluntary administrator also becomes liable for health, safety, tax, environmental and employer obligations. All of these obligations mean increased risk to the voluntary administrator if the company continues to do business during the voluntary administration.
A flow-on effect of this reduced likelihood of trading is a potential reduction in business goodwill. It is more difficult to convince creditors and customers that a business has ongoing viability when the voluntary administrator has ceased trading. Most creditors see liquidation and voluntary administration as the same thing and so they actually expect the voluntary administration process to fail.
In making the ‘to trade or not to trade’ decision, it is worth observing as well that voluntary administrators are qualified accountants with their own business to run, entirely separate from the voluntary administration process. Trading would need to be integrated with their already extensive existing duties. One circumstance that is foreseeable is where the voluntary administrator has multiple jobs on foot and decides to cease trading because they don’t have the capacity to oversee trading in all of their appointments.
Finally, it should be observed that voluntary administrators have little financial incentive to continue trading — they are paid hourly, not on the basis of business success. Their financial incentive is to bill hours in the day (to any job) and there is no success fee payable for a successful turnaround. In fact, voluntary administrators make more fee revenue if the voluntary administration fails and, rather than going into a DOCA (and the company passing back to the directors), the company goes into liquidation. In a liquidation the insolvency practitioner enjoys another year (or two) of fee revenue.
In short, your average voluntary administrator is no Elon Musk — someone willing to put everything on the line in aid of their business vision. In most cases the sensible path for the voluntary administrator will be to focus on risk minimisation rather than to continue trading. They prefer to stay in the office anyway.
Is it a bad thing that voluntary administrators limit potential liability by refusing to trade?
On the one hand, the personal liability of voluntary administrators and the tendency not to like trading is unfortunate. It means that voluntary administrators may refuse to trade in appointments where there is a viable business proposition, but a low asset base or unstable cash flows. In those cases, the business lacks the assets or cash flows to provide sufficient indemnity for the voluntary administrator, so it is not worth them continuing to trade after being appointed and the business ends up being liquidated.
On the other hand, voluntary administration is an expensive proposition, and perhaps voluntary administrators should not be appointed in the cases outlined above anyway, as it is less likely that voluntary administration is the appropriate tool. It is well-established that voluntary administration is more successful for larger businesses than it is for small ones (read more in our Complete Guide to the Small Business Restructuring Process).
Some would also argue that this personal liability of voluntary administrators encourages prudence and vigilance from voluntary administrators, and means that the decision to take on an appointment is taken seriously. It is clear that the system of voluntary administration is designed this way and it was a policy decision to take insolvent companies out of the hands of directors. Voluntary administrators are safe hands for creditors and their potential personal liability means that they have a strong incentive not to make the company’s debt position worse through trading that is cash flow negative.
If we expect voluntary administrators to take on businesses and continue trading, as a matter of course, we would need a complete redesign of the insolvency system to provide the appropriate incentives to voluntary administrators and protect them from personal liability. There is no appetite to do that at the present time, however.
This means that it is crucial that directors carry out due diligence before commencing a voluntary administration. If trading is going to be loss making (even though no pre-appointment debt is payable), then it is extremely unlikely that a voluntary administrator will continue to trade. If a voluntary administrator makes a pre-appointment commitment, there is no legal obligation for them to meet that obligation.