The Complete Guide to Illegal Phoenix Activity
Illegal phoenix activity — the ‘re-birth’ of a business in new corporate feathers to avoid its obligations — has been a major concern of regulators in Australia for the last 25 years. In this ultimate guide we explain everything you ever wanted (and didn’t want) to know about phoenix activity in Australia.
- What is the definition of phoenix activity?
- Illegal phoenix activity in Australia
- History of illegal phoenix activity and regulation in Australia
- What’s wrong with phoenix activity?
- So, why do directors engage in or facilitate phoenix activity?
- What do ‘phoenix operators’ look like?
- Consequences of illegal phoenix activity: creditor-defeating dispositions
- Consequences of illegal phoenix activity: potential accounting fraud
- Preventing illegal phoenix activity
- What is the difference between phoenix activity and pre-pack insolvency arrangements (‘pre-packs’)?
- Possible future directions for illegal phoenix activity: Labor policies
- Possible future directions for illegal phoenix activity: Anderson Report 3
What is the definition of phoenix activity?
There is no universally agreed upon definition of ‘phoenix activity’ (or ‘phoenixing’, as it is sometimes called), whether in Australian law or wider commentary. While it is mentioned in the ‘Bible’ of Australian commercial law, the Corporations Act 2001 (Cth), it is not defined there. Nor is it defined in any other piece of legislation currently on the books.
Focusing on the word itself we can say that, in broad terms, phoenixing occurs where there is ‘re-birthing’ of an enterprise by stripping one company of its assets and transferring them into a new entity which is essentially the same business.
The Australian Securities Commission released a paper in in May 1996 titled ‘Project One: Phoenix Activities and Insolvent Trading’. There it was suggested that phoenix activity can be divided into three categories:
- Innocent phoenixing: Where a struggling business under financial stress tries to legally reinvent itself, leading to practices such as inappropriate bookkeeping, poor financial recording, and mismanagement of cash flow;
- Occupational hazard: Where an operator is forced, coerced, or encouraged into phoenix behaviour by virtue of their skillset and/or industry focus. This necessitates the creation of businesses by locking them in to a particular career;
- Careerist offenders: Where individuals or groups deliberately engage in recurrent phoenix activities for the purpose of exploiting the system for personal financial gain.
Listen to Ben Sewell explain how phoenix activity works on the Tax Talks podcast.
In December 2014 the Phoenix Research Team released a more up-to-date classification of phoenix activity in the paper ‘Defining and Profiling Phoenix Activity’. Phoenix activity was again analysed by different categories according to the intentions of directors and their advisers. They suggested that there were five distinct forms of phoenix activity:
- Legal phoenix: Also known as ‘business rescue’, where directors have no intention to defraud creditors, and saving the business (but not the company) is the best course of action for all stakeholders and the economy in the circumstances;
- Problematic phoenix: Technically legal, where there is no evidence of directors intending to defraud creditors, but the net effect of the phoenixing is not beneficial to creditors or wider society (may involve director/s who have had past business failures);
- Illegal type 1: Where a company was set up with the best intentions, but finds itself in financial difficulty, whether by bad practice or unfortunate circumstances. An intention to defraud creditors is then formed at or immediately before the time of business failure;
- Illegal type 2: Phoenix as a business model, where the company is incorporated and designed for the sole purpose of engaging in personally profitable phoenix activity (i.e. the business was never operated to succeed);
- Complex illegal: Phoenix as a business model which also coincides with and occurs alongside more serious crimes perpetrated by the same individuals within the same framework. This involves practices such as creating false invoices (e.g., GST fraud), false identities, fictitious transactions, money laundering, visa breaches, and misusing migrant labour. The figure below captures the various dimensions of complex illegal phoenix activity.
In light of these different categories, the important question becomes not ‘what is phoenix activity?’, but rather, ‘which phoenix activity is legal?’, or, ‘which phoenix activity should be illegal’?
Illegal phoenix activity in Australia
Focusing on the illegal element we arrive at the definition used by the Australian Securities and Investments Commission (ASIC):
Illegal phoenix activity occurs where there has been a transfer of assets (often below market value) to a new company, and the old company deliberately liquidated with the intention of defeating the interests of creditors (such as the ATO and employees and suppliers).
This was also the definition used in the explanatory memorandum accompanying the recent anti-phoenixing legislation introducing the concept of a ’creditor-defeating disposition’ (more on this below).
While there may be no offence specifically called ‘phoenix activity’ at the moment, there are a range of ways in which the existing law prohibits this activity and which might be used to take action against individuals.
The persons or bodies that can pursue directors who undertake phoenix activity, and the potential law breaches that may be involved, include:
- Liquidators: They may commence actions against directors for uncommercial transactions, insolvent trading, unreasonable director-related transactions, and creditor-defeating dispositions against directors and their associates;
- ASIC: It may take action against directors for breaches of duties (e.g., the duty to act in the interests of the company and the duty to act for a proper purpose) and may appoint their own liquidators. It may also direct that any property that has been transferred as a creditor-defeating disposition, be transferred back;
- Australian Tax Office (ATO): Appointing and funding liquidators to take actions;
- Prosecutors: Accepting prosecution briefs where there is an element of dishonesty in the phoenix activity and it therefore constitutes an offence. We consider this in more detail below under ‘Consequences of illegal phoenix activity: breaches of the criminal law’;
- Fair Entitlements Guarantee, Department of Employment: Taking action against negligent liquidators and funding action by diligent liquidators.
A common complaint of creditors is that, as the liquidator of the phoenix company often has no funds, they do not undertake serious investigations and initiate enforcement action.
Below we consider how illegal phoenix activity may have first come about, and how it has been regulated to date.
Watch Ben Sewell interviewed by Lauren Willgoose about phoenix activity and the law.
History of illegal phoenix activity and regulation in Australia
1890s-1970s: Abuse of the Corporate Form
It is hard to say when exactly illegal phoenix activity first started occurring. It may have existed for as long as companies have been in existence. However, phoenix activity relies centrally on two key concepts of corporate law which were confirmed by law in 1896 in Salomon v A Salomon & Co Ltd  UKHL 1:
- Companies have a distinct legal personality;
- Companies have limited liability.
It is these two features of the company that allow the directors involved in phoenix activity to ‘wash their hands’ of the old company, and begin afresh with the new company (for more on this connection see Anderson, H. (2017). ‘Corporate Law and the Phoenix Company’ in Roman Tomasic (ed), Routledge Handbook of Corporate Law. Routledge).
Illegal phoenix activity is a subset of a broader range of behaviour sometimes known as ‘abuse of the corporate form’, which has been happening ever since the nature of the corporation was defined in law. One of the oldest types of corporate abuse is ‘trading fraud’: This occurs where a company has built up a reputation with existing suppliers/creditors. The company managers or directors then intentionally continue to incur debt, with a plan to wind up the company without paying. This is an old-fashioned mafia tactic, entertainingly explored in the TV series ‘The Sopranos’: In Episode 23, “Bust Out”, the owner (and director) of a sporting goods company owed a substantial gambling debt to the Mob which he couldn’t pay. He was forced (at gunpoint) to keep ordering goods from established suppliers, and making trivial purchases (e.g., airline tickets) until his store went bankrupt.
1970-1984: ‘Bottom of the Harbour’ Schemes
A form of corporate abuse prominent in Australia through the 1970s, and a precursor to modern phoenix activity, was the ‘bottom of the harbour’ tax avoidance schemes. In these schemes, a company accumulated profits, and transferred all its assets to a new company, before taxes fell due. After transferral of the assets the company was sent to the “bottom of the harbour”. In the end, the ATO, as well as other unsecured creditors were left out of pocket.
This behaviour was uncovered as part of the ‘Costigan Commission’: an Australian royal commission of inquiry, concluded in 1984, formally titled the ‘Royal Commission on the Activities of the Federated Ship Painters and Dockers Union’. This, as well as the discovery of similar tax avoidance schemes in the Royal Commission of Inquiry into Drug Trafficking, have been described as “perhaps the biggest series of frauds in Australian criminological history” (Frieberg, A. (1987). “Abuse of the Corporate Form: Reflections from the Bottom of the Harbour”).
1984- 2003: The Phoenix Activity Inquiries
Throughout the 80s, phoenix activity became increasingly prominent in the public eye. In 1994, the first public inquiry into the practice in Australia was initiated: the Inquiry of the Parliament of Victoria’s Law Reform Committee, titled ‘Curbing the Phoenix Company’. In that inquiry, a range of submissions were heard, and a number of cases considered, relating to phoenix activity. Cases examined by that committee included:
- Jeffree v NCSC (1989) 7 ACLC 556 (Western Australia). In that case, a swimming pool company was subject to a commercial arbitration decision that went against it. In response, a director allowed the company to sell the business name and assets of the company to another one of that director’s companies. This meant that by the time the arbitration award was finalised, the original company was an assetless ‘shell’;
- A specific real estate company was placed in liquidation with significant debts arising out of litigation. On the same day the application for liquidation was made, a company with the same directors received a licence from the Estate Agents’ Board. The company appeared to carry on exactly as it had before, with the same address, same staff and directors (note, it is unclear to this author, from the description in this inquiry, whether assets were transferred in an instance of illegal phoenix activity).
The Law Reform Committee found that it could not accurately quantify the extent of illegal phoenix activity occurring. However, it was satisfied from the submissions it received, as well as ASIC and ATO statistics on assetless de-registrations, and payroll taxes owing on liquidation, that a major problem existed.
As mentioned earlier, in 1996, the Australian Securities Commission (what is now called ‘ASIC’) released a research paper looking at phoenix activity. This paper which drew on surveys and in-depth interviews, suggested that any definition of illegal phoenix activity needs to be wide enough to cover a range of conduct. Specifically:
- Phoenixing covers not just the transfer of assets, but also purposefully wasting them prior to insolvency;
- Phoenixing may not always involve the same directors or managers running the new business, as the old one. Their family members or other related parties could assume these roles.
The 2003 Royal Commission into the Building and Construction Industry, known as the ‘Cole Royal Commission’, examined phoenix activity in the construction industry. It identified cases of companies ‘phoenixing’ again and again. Observing that:
There are extreme examples of self-interest, exercised in disregard of the effect on others. Phoenix companies epitomise the problem of a culture of self-interest. Many, including the Australian Taxation Office (ATO), identified building and construction as one of the industries most susceptible to phoenix company activity.
This commission called for an increase in the maximum penalties available for illegal behaviour relating to phoenix activity.
2005-2013: Inquiries into Phoenix Activity
In 2005, the Assetless Administration Fund (‘AAF’) was introduced by ASIC. Its purpose was to fund insolvency practitioners for companies with few assets. Note, funding is only available under this scheme in specified cases, such as where director banning proceedings may occur, or where there is the possibility of court action for director misconduct.
This fund appears to not have been taken up very often for the purposes of investigating phoenix activity. For further analysis of this fund, and related measures that came out of this paper, see Anderson, H., (2014). ‘Directors’ Liability For Fraudulent Phoenix Activity – A Comparison of the Australian and United Kingdom Approaches’.
A 2009 paper from the Treasury, the ‘Action against Fraudulent Phoenix Activity Proposals Paper’, focused on the potential use of illegal phoenixing to avoid tax liability. In response to this paper, several recommendations were taken up by the Government and passed into legislation:
- The Corporations Amendment (Phoenixing and Other Measures) Act 2012 (more on this below);
- The Tax Laws Amendment (2012 Measures No 2) Act; Pay As You Go Withholding Non-compliance Tax Act 2012. This altered the Director Penalty Notice framework, so that directors are personally liable to remit income tax withholding amounts, if the company has not reported those amounts.
A Corporations Amendment (Similar Names) Bill was developed to deal with phoenixing companies using similar name to their predecessors, but after significant opposition, it was never introduced to Parliament.
A 2012 PricewaterhouseCoopers Report to the Fair Work Ombudsman, ‘Phoenix Activity: Sizing the Problem and Matching Solutions’, focused on the impact that phoenixing can have on employees. It defined phoenix activity as a deliberate and systematic liquidation of a corporate trading entity with the illegal or fraudulent intention to:
- Avoid tax and other liabilities (e.g., employee entitlements);
- Continue the operation of the business through another entity.
The 2012, NSW Independent Inquiry into Construction Industry Insolvency, commissioned by the New South Wales Government, examined phoenix activity in the construction industry in NSW. Problematic activity identified included the common practice of head contractors creating new companies for each new construction project, as a “harm minimisation strategy”.
The Corporations Amendment (Phoenixing and Other Measures) Act 2012 dealt with one of the ways in which phoenixing can disadvantage employees. There had been a practice of companies with limited or no assets (perhaps due to phoenixing), being ‘abandoned’ by their directors, without being formally wound up. One unfair consequence of this, was that those employees were not able to access the financial support available through the General Employee Entitlements and Redundancy Scheme (‘GEERS’): this scheme was only available to employees after company liquidation.
This amendment to the Corporations Act 2001 (Cth) gave ASIC the power to place the company in liquidation, so that employees could access GEERs. In addition, with the power to initiate liquidation, this law allowed for the possibility of that liquidator investigating and taking action with respect to any possible phoenixing behaviour.
The opposition Labor party released a draft Fair Work Amendment (Protecting Australian Workers) Bill 2016 shortly before the 2016 federal election. This would have amended the Fair Work Act 2009 (Cth) to include a provision requiring the executives of “failed phoenix companies” to pay out employee entitlements owing at the time of liquidation. This has not been implemented by the Government to date.
2014-2020: Taskforce galore – and further inquiries
The Phoenix Taskforce was introduced in 2014, through an amendment to the Taxation Administration Regulations. That amendment made it possible for the ATO to disclose tax information to other government agencies (and their officers), and thereby better combat illegal phoenix activity.
The taskforce consists of 38 government agencies working together, with a stated purpose to detect, reduce and deter illegal phoenix activity. In addition to raising nearly $1.33 billion in liabilities in its review and audit of illegal phoenixing, it has succeeded in prosecuting a range of individuals involved in illegal phoenix activity, as well as a range of other successful outcomes.
In addition to these actions, the taskforce has also advised on legislative reform. One of the outcomes was the law relating to creditor-defeating dispositions. This is discussed in more detail below.
In 2015, another taskforce headed by ATO, the Serious Financial Crime Taskforce began, with an explicit focus on illegal phoenix activity (among other things). This taskforce (naturally) is focused on the criminal aspects of illegal phoenix activity.
Also in 2015, the Senate Economic References Committee released a report on Insolvency in the Australian Construction Industry. Addressing the impact of illegal phoenix activity, the committee recommended:
- More resources aimed at preventing, detecting, and prosecuting instances of illegal phoenix activity;
- Regulators increase engagement efforts with industry participants aimed at increasing and enhancing information flows.
From 2016-2017, the Black Economy Taskforce looked into illegal phoenix activity. It recommended a range of more significant penalties and enforcement for phoenixing.
Some of the recommendations made over this period were finally captured in the 2020 law reform relating to creditor-relating dispositions.
The Productivity Commission’s 2015 report Business Set-up, Transfer and Closure considered the impact of illegal phoenix activity on the Australian economy. It recommended the introduction of a Director Identification Number (‘DIN’). As of 12 June 2020, this has been implemented through the passing of the Commonwealth Registers Act 2019 – a legislative package made up of five bills introduced in December 2019 to streamline the business registration process into a ‘mega registry’ of over 30 existing registries in an attempt to combat phoenix activity and increase efficiency through automation under the supervision of the ATO. The discussed timeframe for implementation of the Act, and by extension the DIN in early 2021 may be pushed back due to economic issues caused by COVID-19, but it will be operational by 2022.
The rationale behind the introduction of the DIN is that it will allow for better tracking and monitoring of any directors involved in phoenixing, while also protecting their privacy through anonymising them until wrongdoing is uncovered. The proposed procedures to obtain a DIN will be outlined in the data standards which will be consulted on publicly in late 2020. The DIN will be a unique identifier that can be used to trace a directors’ historic professional profile, positions of office and corporate relationships.
Directors will be required to apply for a DIN before a director appointment. For the first 12 months (transitional period) of the operation of this law, an appointed director will have 28 days to apply for a DIN, while existing directors will have 15 months. The legislation gives the Registrar powers to issue and cancel DINs, extend application periods, require identity verification, maintain records and issue infringement notices. It also creates a strict liability offence for directors performing their duties without a DIN. Civil and criminal penalties may apply to directors who fail to apply for a DIN within the timeframe, deliberately falsify their identity when applying, apply for multiple DINs or intentionally provide a false DIN to a government body or corporation.
What’s wrong with phoenix activity?
Why have there been so many inquiries, investigations, and law changes in relation to phoenix activity in Australia? What exactly is wrong with phoenix activity?
Principally, illegal phoenix activity harms specific creditors by defrauding them out of being paid debts. Arguably, the Australian Tax Office (ATO) is the creditor with the most to lose as it misses out on income tax, PAYG, GST, and other taxes.
Perhaps even more significant, is the harm to the wider economy through flow on effects to cheated individuals and businesses and a loss of confidence that bills will be paid. The unfair advantage this gives to phoenix companies over their competitors also damages the efficiency of the market: How can you compete with a business that can use phoenixing to repeatedly avoid paying its bills?
A July 2018 report by PricewaterhouseCoopers, prepared for the Phoenix Taskforce, estimated the annual direct cost to businesses, employees and government as a result of potential illegal phoenix activity to be between $2.85 billion and $5.13 billion in 2015-16.
Watch Ben Sewell deliver a seminar on the good, the bad and the ugly of phoenix activity.
So, why do directors engage in or facilitate phoenix activity?
Given the wide-ranging damage that phoenix activity can have, why do company directors do it? The most obvious reason, perhaps, given the ATO’s position as a major creditor, is the rationale of evading taxes. However, looking more specifically at psychological motivations of directors, it is worth considering:
- It may be a temporary solution to a crisis – i.e., recovering from the loss of a principal customer, or the sickness of the main proprietor;
- Directors may be trying to finance drug, gambling, or alcohol problems;
- Businesses with unsustainable business models may be looking for a ‘quick fix’ – in some industries it may even be expected that phoenix activity is priced into quotes;
- It may be a response to insolvency caused by normal issues like poor management, a big project that lacks sufficient working capital and/or poor accounting systems.
What do ‘phoenix operators’ look like?
Directors might make the final decision to engage in phoenix activity, but they don’t operate in a vacuum. Where do they get the idea from? While there is no systematic empirical evidence to draw upon, it is known that some accountants and former liquidators, as well as lawyers, are promoting asset stripping. Sometimes these individuals are known collectively as ‘phoenix operators’.
Much has been written in the media about the ‘unmasking’ of phoenix operators: These are the people that are the co-ordinators of phoenix activity and may represent a number of clients. The ATO has stated in the past that it is targeting both ‘high risk’ and ‘medium risk’ phoenix operators with strong scrutiny and legal sanctions.
In its own reports, the Phoenix Research Team lists several cases of specific phoenix operators including a solicitor, management consultant, barrister, insolvency practitioner, and a few company directors. However, none of these examples illustrates the “high risk” offenders that are currently being targeted by the ATO.
A good example of the latter activity might be the activity discussed in the ‘Plutus Payroll Scam’. Payroll scams involve a business being approached by a phoenix operator who suggests to the business that it outsources all its payroll and staffing to the operator, who will take care of it and give the business a kickback.
In the Plutus case specifically, the operation involved using dummy directors and rebirthing companies over and over again. Its clients were various businesses around Australia that had outsourced their payroll and received a kickback, which was a proportion of the unpaid income tax and PAYG tax.
What can creditors do to protect themselves?Even if enforcement action against illegal phoenix activity were to improve, from a creditor’s point of view, it is better to take risk minimisation steps to avoid exposure to phoenix company activity rather than fund liquidator litigation or hope ASIC will put the company into liquidation and support action.
The key techniques for risk minimisation are:
- Having credit limits on goods and services contracts;
- Reviewing contracts and making sure they are up to date with the latest developments in the law;
- Taking security and utilising the PPSR to become a secured creditor; and
- Avoiding unethical businesses.
Consequences of illegal phoenix activity: creditor-defeating dispositions
There has been a perception for a while now that liquidators do not have enough mechanisms available to them to deal with illegal phoenix activity. Creditor-defeating dispositions have been introduced to give liquidators another arrow in their quiver. These reforms were introduced in February 2020 within the Treasury Laws Amendment (Combating Illegal Phoenixing) Act 2019 (Cth) as part of an attempt to crack down on phoenixing across Australia.
A creditor-defeating disposition occurs when a company transfers property for less than its reasonable market value before an insolvent liquidation. This process typically occurs during the winding up of a company, and may take place as part of a broader plan of illegal phoenixing. This has the effect of preventing, hindering or significantly delaying the company’s assets from becoming available to meet the demands of creditors.
The Corporations Act 2001 (Cth) also sets new duties to prevent creditor-defeating dispositions, with liability now extending to persons who facilitate a company making a creditor-defeating disposition, including professional advisers. This widens the scope to better deter phoenixing activity and provides greater recourse for liquidators to receive compensation.
Such dispositions will be void under the new reforms and remedies will be available to creditors and liquidators, ranging from recovery of the property, to compensation, to criminal and civil penalties for individuals and corporate bodies that contravene the duties outlined above. These reforms work to deter potential promoters of phoenix activity and provide a new mechanism that liquidators can use to claim assets.
The reforms have also bolstered ASIC’s ability to combat illegal phoenixing activity and protect creditors by directly enforcing the creditor-defeating disposition provisions. ASIC now has the ability to make an administrative order, at the request of a liquidator, or on its own initiative. This order can state that the property involved in a creditor-defeating disposition be returned, that the amount representing the benefit be paid or that an amount that ‘fairly represents’ the proceeds be paid. This extends the recovery provisions available to liquidators and improves their ability to recover assets lost through illegal phoenixing.
What are the details of the new provisions?
The Treasury Laws Amendment Act amended the Corporations Act 2001 (Cth) to create a new definition for creditor-defeating dispositions, to impose duties to prevent such dispositions, to provide for remedies and to bolster ASIC’s powers.
Creditor-defeating dispositions are outlined in s 588FDB of the Corporations Act 2001 (Cth). The section dictates that a disposition of property is a creditor-defeating disposition if:
- The consideration payable to the company for the disposition was less than the lesser of the following at the time the relevant agreement for the disposition was made or, if there was no such agreement, at the time of the disposition:
- the market value of the property; or
- the best price that was reasonably obtainable for the property, having regard to the circumstances existing at that time.
- The disposition has the effect of:
- preventing the property from becoming available for the benefit of the company’s creditors in the winding-up of the company; or
- hindering, or significantly delaying, the process of making the property available for the benefit of the company’s creditors in the winding-up of the company.
The legislation further extends the concept of a disposition by providing that:
- If a company does something that results in another person becoming the owner of property that did not previously exist, the company is taken to have made a disposition of the property;
- If a company makes a disposition of property to another person and the other person gives some or all of the consideration for the disposition to a person (third party) other than the company, then the company is taken to have made a disposition of the property constituting so much of the consideration as was given to the third party.
A creditor-defeating disposition will be voidable under s 588FE(6B) of the Corporations Act 2001 (Cth) if three criteria are met:
- The transaction is a creditor-defeating disposition of property of the company.
- At least one of the following applies:
- the transaction was entered into, or an act was done for the purposes of giving effect to it, when the company was insolvent, during the 12 months ending on the relation-back day or both after that day and on or before the day when the winding up began;
- the company became insolvent because of the transaction or an act done for the purposes of giving effect to the transaction during the 12 months ending on the relation-back day or both after that day and on or before the day when the winding up began;
- less than 12 months after the transaction or an act done for the purposes of giving effect to the transaction, the start of an external administration of the company occurs as a direct or indirect result of the transaction or act; and
- The transaction, or the act done for the purpose of giving effect to it, was not entered into, or done:
- under a compromise or arrangement approved by a Court under s 411; or
- under a deed of company arrangement executed by the company; or
- by an administrator of the company; or
- by a liquidator of the company; or
- by a provisional liquidator of the company.
Duties relating to creditor-defeating dispositions
The Corporations Act 2001 (Cth) also sets out a range of new duties to prevent creditor-defeating dispositions. In particular it sets out that:
- An officer of a company must not engage in conduct that results in the company making a creditor-defeating disposition of property of the company;
- A person must not engage in conduct of procuring, inciting, inducing, or encouraging the making by a company of a disposition of property that results in the company making the disposition of the property.
The key takeaway here is that liability now extends to other persons who facilitate a company making a creditor-defeating disposition, including professional advisers such as solicitors. This widens the scope to better deter phoenix activity and provides greater recourse for liquidators to receive compensation.
Remedies and penalties relating to creditor-defeating dispositions
If a creditor-defeating disposition has occurred, and that disposition is determined by a court to be voidable, a range of remedies will be available to creditors and liquidators. The primary remedy is the recovery of the property that has been transferred, which intends to restore the parties to the position they would have been in but for the disposition. In addition, a court may also provide that compensation be paid to creditors or liquidators where necessary. It would be expected that liquidators would prefer a claim for cash compensation.
Furthermore, the new regime introduces criminal and civil penalties for individuals and corporate bodies that contravene the duties outlined above. To be held criminally liable, the individual or body must have been reckless as to the result of their conduct. To be held civilly liable, the individual or body must have been unreasonable in their conduct. If such a standard is proven, hefty penalties can be enforced by the court including fines of up to 4,500 penalty units for individuals and 45,000 penalty units for corporations. Individuals can also be imprisoned for up to 10 years and corporations can be fined up to 10% of their annual turnover.
Powers for ASIC
Finally, the reforms have bolstered ASIC’s ability to combat illegal phoenix activity and protect legitimate creditors by enforcing the creditor-defeating disposition provisions. ASIC now has the ability under s 588FGAA to make an administrative order at the request of a liquidator or on its own initiative stating that the property involved in a creditor-defeating disposition be returned, that the amount representing the benefit be paid or that an amount that ‘fairly represents’ the proceeds be paid. Any failure to comply with the order, is an offence which carries a fine of up to 30 penalty units or imprisonment of up to six months, or both. This extends the recovery provisions available to liquidators and improves their ability to recover assets lost through illegal phoenixing.
A final note on creditor-defeating dispositions
It is worth emphasising that the new law relating to creditor-defeating dispositions stands alongside existing mechanisms which could be used to impose civil liability for phoenix activity. Consider, for example:
- Breaches of existing duties of directors in the Corporations Act 2001 (Cth) could be involved in phoenix activity. For example, a director facilitating phoenix activity could be breaching their duty to act in good faith in the interests of the company;
- Breaches of the Fair Work Act 2009 (Cth) may be involved in illegal phoenix activity. Under Section 550 of that Act, those involved in a contravention of a civil penalty provision of the Act, will be treated in the same way as actual contravention. This means, for example, that any illegal phoenix operators encouraging the depriving of employee benefits under the Fair Work Act 2009 (Cth), can be subject to significant civil penalties.
Consequences of illegal phoenix activity: potential accounting fraud
We mentioned that the new law relating to creditor-defeating dispositions is another arrow in the liquidator’s quiver. What other ways might illegal phoenix activity contravene existing laws? Here we examine how illegal phoenix activity can, in some cases, involve accounting fraud.
What is accounting fraud?
Margret and Peck defined accounting fraud in their 2015 book, Fraud in Financial Statements (New York : Routledge) as follows:
Fraud in financial statements is an act of deliberate deceit that results in a misleading representation, material misstatement, or intended exclusion in a business entity’s financial accounts. The deception is committed with the intent to mislead shareholders and other stakeholders about the financial state of the business entity. The fraud may misleadingly relate financial circumstances, or an otherwise non-financial material fact.
The authors also referred to Cressey’s theory of the fraud triangle which, when simplified, identifies the influences leading to fraud: opportunity, rationalisation, and pressures. These influences are also likely to affect phoenix operators and shape their choice to engage in phoenix activity.
How is accounting fraud captured in Australian law?
Just as with illegal phoenix activity there is no one single offence that captures accounting fraud in Australia. Rather, companies, and their directors and officers, have a range of obligations in relation to keeping and presenting financial records and it is a breach of the law, and in some cases, an offence, to dishonestly breach those obligations. For example, under section 286 of the Corporations Act 2001 (Cth), a company must keep financial records that:
- Correctly record and explain financial position and performance; and
- Enable fair and true financial statements to be prepared and audited.
Under section 344 of that same Act it is an offence to breach those obligations dishonestly. This dishonesty could be established in various different ways such as through evidence of deliberate destruction of records or evidence that a decision was made not to keep records to avoid detection of an offence.
Is phoenix activity a form of accounting fraud?
The short answer is no. Accounting fraud, as seen in the definition above, is characterised by ‘deliberate deceit’ with the ‘intent to mislead’. Applying this definition to the categories of phoenix activity in ‘Defining and profiling phoenix activity’ discussed earlier, it will only definitively catch complex illegal phoenix activity, and may occasionally apply to illegal type 1 and 2.
A more helpful way to think about the relationship between phoenix activity and accounting fraud is that phoenix activity might be carried out in conjunction with fraudulent accounting practices. Phoenix activity in its more serious forms can be facilitated by accounting fraud.
It would also be possible for a phoenix operator, engaging in below market value transactions for the transfer of assets, to make misleading representations or material misstatements about the health of the company to creditors in order to quiet any suspicions or concerns.
The distinction between the two is starker when considering phoenix activity in light of the creditor-defeating disposition reforms. Accounting fraud concerns deceit through false documentation whereas creditor-defeating dispositions concern the valuation of property.
Understanding how the two concepts, phoenix activity and accounting fraud, are related, and then looking at how accounting fraud is policed and penalised, is an essential step in working out how best to respond to phoenix activity in its ‘illegal’ forms.
Consequences of illegal phoenix activity: potential breaches of the criminal law
As well as some of the civil penalties and remedies we have considered so far, illegal phoenix activity can constitute a crime in some cases. ASIC itself states:
“Illegal phoenix activity is a serious crime and may result in company officers (directors and secretaries) being imprisoned”
If there is no crime specifically called ‘phoenix activity’ in the statute books, how could it constitute an offence? We mentioned the possibility of offences involved in accounting fraud. What other criminal offences could be committed in pursuit of illegal phoenix activity?
Below we set out some of the situations where phoenix activity could (depending on the facts of the case) constitute a crime, some punishable by imprisonment of up to ten years.
Creditor-defeating dispositions and other duties under the Corporations Act 2001 (Cth)
Directors have a duty to prevent creditor-defeating dispositions. If they fail to do so they may be liable for a civil penalty. In addition, if there is knowledge, intention, or recklessness with respect to a disposition being creditor-defeating, a crime is committed. This is punishable by up to ten years imprisonment.
In addition, breach of general directors duties can sometimes constitute a criminal offence under section 184 of the Corporations Act 2001 (Cth). Duties of directors include:
- Duty to act in good faith in the interests of the company as a whole;
- Duties of reasonable care and diligence;
- Duty not to make improper use of the director’s position;
- Duty not to make improper use of information;
- Duty not to trade while insolvent;
- Duty not to act for an improper purpose;
- Duty to avoid conflicts of interest.
In general, it is a criminal offence for a director to be reckless or intentionally dishonest in their failures to comply with these duties. In some cases, illegal phoenix activity could include such behaviour.
Crimes against the Commonwealth
Illegal phoenix activity can also constitute, or involve, crimes under the Criminal Code Act 1995 (Cth) which sets out crimes against the Commonwealth (i.e. federal agencies such as the ATO or the Clean Energy Regulator).
All subsequent references below are to sections of the Criminal Code Act 1995 (Cth). Possible offences that might be committed (depending on the facts) when engaging in illegal phoenix activity include:
- Obtaining property by deception. This means dishonestly obtaining property of a Commonwealth entity (e.g., the ATO or another Government agency) with the intention of depriving them of that property (see section 134.1);
- Dishonestly obtaining a gain. This means dishonestly gaining a financial advantage from a Commonwealth entity (see section 135.1(1)). This crime and the prior one, before the repeal of those sections in 2001, were prosecuted under sections 29B (imposition upon the Commonwealth) or 29D (defrauding the Commonwealth) of the Criminal Code Act 1995 (Cth);
- Knowingly giving false or misleading information to a Commonwealth entity, or someone exercising a power in relation to a Commonwealth law, or where the information is given in compliance with a Commonwealth law (see section 137.1);
- Knowingly producing documents in relation to compliance with Commonwealth laws that are false or misleading (see section 137.2);
- Forging documents (see section 144.1), and/or using a forged document (see section 145.1) and/or possessing a forged document (see section 145.2). This means producing, using, or possessing false documents with the intention of dishonestly inducing public officials to accept them as genuine;
- Giving information derived from false or misleading documents (see section 145.5);
- Causing a person to enter into debt bondage (see section 271.8). This involves causing someone under your control to enter into a relationship where:
- the debt owed or claimed to be owed is manifestly excessive; or
- the reasonable value of those services is not applied toward the liquidation of the debt or purported debt;
- the length and nature of those services are not respectively limited and defined.
- Dealing in proceeds of crime (covers money or property worth any value up to $1,000,000 or more, see sections 400.3, 400.4, 400.5, 400.6, 400.7, 400.8);
- Dealing with property reasonably suspected of being proceeds of crime (see section 400.9).
Preventing illegal phoenix activity
As well as mechanisms in place to penalise illegal phoenix activity, there are also a range of mechanisms in place to either prevent or thwart attempts at phoenixing.
Alongside the recent law change introducing the concept of a ‘creditor-defeating disposition’, several law changes were made aimed at preventing illegal phoenix activity. These changes included:
- A prohibition on improper backdating of director resignations. Previously, directors (potentially of illegally phoenixed companies) were able to backdate a resignation easily. This means, those directors could (falsely) claim that they were not a director at the time of any illegal phoenix activity, as they had resigned. This new law change, via section 203AA of the Corporations Act 2001 (Cth), means that the resignation only takes affect when ASIC is notified, except under exceptional circumstances;
- A prohibition on leaving companies with no directors. A director will not be able to resign if this would leave the company with no directors;
- Personal liability for unpaid GST. This is contained in a new amendment to the Tax Administration Act 1953 (Cth), Division 268, Schedule 1. This means that a director can be held personally liable for unpaid GST if they do not promptly go into external administration or do not comply with a Director Penalty Notice. The previous law only made them liable for unpaid PAYG and superannuation. This should make it more difficult for directors to avoid paying tax liabilities through phoenixing.
- Withholding tax refunds. Under new section 8AAZLG of the Tax Administration Act 1953 (Cth), the ATO is able to withhold a tax refund where there is a failure to lodge another return or other relevant information that may impact on the refund. This is designed to prevent, for example, a company receiving a large GST refund and illegally phoenixing, while it has yet to submit its corporate income tax return.
These new mechanisms sit alongside mechanisms that the ATO already has to deal with suspected illegal phoenixing. For example, clause 255-100 of the Taxation Administration Act 1953 (Cth), Schedule 1, provides that the Commissioner may require a security deposit for the payment of a future tax liability where the Commissioner believes:
- The individual intends to carry on that enterprise for a limited time only; or
- The Commissioner reasonably believes that the requirement is otherwise appropriate, having regard to all relevant circumstances.
Either of these grounds could be used to require a security deposit where there is reason to believe a company may be illegally phoenixing.
What is the difference between phoenix activity and pre-pack insolvency arrangements (‘pre-packs’)?
Under the heading ‘what is the definition of phoenix activity?’ the possibility of ‘legal phoenix activity’ was mentioned. While not illegal in any way, sometimes pre-pack insolvency arrangements (‘pre-packs’) are confused with phoenix activity. Here we explain the difference between the two.
Pre-packs are still relatively unorthodox in Australia but are implemented regularly in the UK. If properly planned, pre-packs are legal and allow a business to be rescued through a quick transfer of the assets of the insolvent company.
In a pre-pack, the transfer of the business assets is negotiated prior to the appointment of an administrator or liquidator over the insolvent company. The elements of a successful pre-pack are:
- An insolvent company (Oldco);
- The transfer of Oldco’s assets for commercial consideration to a related entity (Newco); and
- A result that is justifiable as commercial to creditors, employees, and other stakeholders.
A pre-pack, done correctly and under professional guidance, falls within the bounds of the law. This is because the ‘safe harbour’ provisions of the Corporations Act 2001 (Cth) allow an individual to continue trading, even if there is a suspicion of insolvency, where:
- At a particular time after the director suspects insolvency, the director develops a course of action that is reasonably likely to lead to a better outcome for the company; and
- The company debt is incurred in connection with the course of action.
Is a pre-pack difficult to undertake?
Once you have determined that a pre-pack can be carried out legally, you need to work out how difficult this process will be for your business to successfully carry out. Generally speaking, it is quite difficult.
The valuation of the business assets of the insolvent company is likely to be difficult. By its very nature, an insolvent company is unlikely to have much goodwill value (who would buy it anyway?) and the valuation of saleable assets on a break-up value could be low. One insolvency firm advocates that the pre-pack asset sale price should be the mid-point of the liquidation (i.e. fire sale) and going concern values of the business assets.
Why would an insolvent company undertake a pre-pack?
A pre-pack sale is generally quick, which can enable the business to continue trading through Newco in a liquidation scenario. Existing employees may also be retained by the Newco and the goodwill of the business may be preserved.
The costs of voluntary administration can be substantial and in some cases may exceed the value of the goodwill of the business. In such cases, it may be worth considering whether a pre-pack will increase the returns for creditors by reducing the professional costs of a voluntary administration process and also preserve the goodwill value of a business. Voluntary administrations are generally looked at pessimistically by the market. It is also possible to implement a pre-pack whilst in a safe harbour informal restructure.
Possible future directions for illegal phoenix activity: Labor policies
We have been focused on the Commonwealth Government’s recent reforms to combat illegal phoenix activity. But what might the Australian Labor Party have in store if it is in a position to push phoenix activity reform?
According to Labor’s plan from the 2019 election, phoenix directors described by the political party as “dodgy” will be named and shamed, in an attempt to shore up the taxation system. The tax issue isn’t the only motivation for this policy, though, with Labor also asserting that its approach to dealing with phoenix companies will help protect vulnerable workers and boost economic productivity.
Labor’s plan included the following:
- A requirement for all company directors to obtain a unique Director Identification Number with a 100-point identification check (note that the DIN has now been enacted in June 2020 through the Commonwealth Registers Act 2019 (Cth) which will take effect in the next 1-2 years)
- Increased penalties associated with phoenix activity, including the possibility for lengthy penal sentences;
- ‘Dodgy’ phoenix directors to be named and shamed publicly;
- A power will be given to the Commissioner of Taxation to enable the worst phoenix tax offenders to be formally disqualified;
- The ‘Tradie Pay Guarantee’ aiming to help protect government subcontractors’
- A new national framework will further bolster the rights of subcontractors and small businesses;
- Federal security of payments, based on the recommendations of the Murray Review, will be established;
- A new $7 million ‘Tradie Litigation Fund’, intended to ensure that tradesmen and women impacted by phoenix companies can take legal action.
While Labor proclaims that it will robustly strengthen legislation in this area, it should also be noted that there have been quite a few prosecutions and enforcement activity related to phoenix companies already. The Fair Work Ombudsman has investigated several high-profile cases. In one case, a business owner in Western Australia was jailed for five years for what was deemed illegal phoenix activity, while in another matter, the New South Wales Supreme Court struck off an advisor after finding him in dereliction of duties. Several other companies have been pursued as well.
Possible future directions for illegal phoenix activity: Anderson Report 3
The Phoenix Project, led by Professor Helen Anderson of Melbourne University released their third and final report on Regulating Fraudulent Phoenix Activity in February 2017. It contains final recommendations on how the government should deal with harmful phoenix activity and engage with stakeholders to facilitate implementation and remains a very helpful guide for future reform. Note that some of the measures have since been introduced into law. It is structured by recommendations for detection, disruption and deterrence. The specific measures recommended are as follows:
- Introduction of a Director Identification Number system to track directors and their histories (this has since been passed as law as of June 2020 to be implemented by 2022);
- Make the process for incorporating companies more transparent: should be online and use the DIN system for identification;
- Reports as to affairs documents (RATA) should require more information about directors, previous company failures and significant asset transfers in the past 12 months;
- Increase the penalties for failing to inform and assist liquidators
- Collect additional information via external administrators’ reports
- Improve the advice and complaint functions on regulator websites
- Increase information sharing between regulators (achieved through the Commonwealth Registers Act 2019 (Cth))
- Make information about companies public and free of charge
- Establish an online register of restricted and disqualified directors
- Increase information sharing between super funds and regulators
- Increase information sharing between trade unions and others
- Provide corporate tax debt data to credit reporting agencies
- Improve collection of statistical data about phoenix activity
- Introduce restricted directorships
- Prioritise director disqualification in the phoenix context
- Increase the maximum duration of ASIC disqualification
- Give other regulators the power to seek disqualification orders
- Increase the penalties for managing companies while disqualified
- Check ABN applicants against restricted and disqualified registers
- Introduce independent valuations of related party transfers
- Limit the backdating of directorships
- Expand the director penalty notice regime
- Require payment of tax and super via Single Touch Payroll
- Clarify the enforcement role of liquidators and increase funding
- Prioritise enforcement action in the phoenix context
- Improve public reporting of enforcement activity
- Expand s 596AB of the Corporations Act 2001 (Cth) to include a civil penalty provision, proved via an objective test, in addition to the criminal offence.
- Increase the maximum penalties for breaches of directors’ duties
- Increase the penalties for Fair Work Act 2009 (Cth)individual liability
- Remove the benefits of harmful phoenix activity
- Clarify accessory orders under the Fair Work Act 2009 (Cth)
- Expressly address the role of professional and pre-insolvency advisers: impose conditions and penalties
Illegal phoenix activity has proved relatively difficult to stamp out in Australia. This may be partly a feature of entrenched culture (e.g., in the construction industry), but also an inherent difficulty in distinguishing perfectly legal asset transfer between companies (such as in a properly executed ‘pre-pack’) from illegal phoenix activity.
However, it is clear that there now exists a range of mechanisms in place for the authorities to pursue illegal phoenix activity including:
- A new law prohibiting creditor-defeating dispositions;
- Existing prohibitions on accounting fraud;
- Existing criminal law provisions;
- A range of powers (particularly those exercised by the ATO) to make illegal phoenix activity less desirable/prevent it in the first place; and
- The yet to be implemented DIN and other organisational changes contained in the Commonwealth Registers Act 2019 (Cth).