Restructuring service businesses in Australia is all about intangibles

As the Australian economy is dominated by small to medium-sized enterprises (SMEs) that provide services (‘service businesses’), this raises the question; are there any specific features of service businesses that affect restructuring efforts? 

In article:

Here we suggest that the predominance of ‘intangible assets’ in these companies tips the scales in favour of restructuring these businesses, rather than breaking them up. The insolvency system is designed to deal with tangibles in an external administration, like plant and equipment and stock, but it finds it difficult to deal with intangibles because they largely evaporate when an external administration process commences. 

The nature of assets in a historic external administration – selling things when a company is wound up

‘External administration’ covers a range of procedures in Australia for dealing with insolvent or distressed corporations. Historically, these businesses tended to have physical/ fixed assets that could be realised as part of the external administration. This included real property (the land and buildings) and personal property (including the equipment, plant, inventory and cash). In the 19^th and first half of the 20^th century this included factories and other manufacturing businesses. 

Insolvent business restructuring, as it exists in Australia, is arguably traceable to 19th century UK statutes which codified the concept of a ‘deed of arrangement’, where creditors could agree to a distribution of assets and the winding up of an estate without significant court involvement. 

A useful survey of these statutes, as well as the history of corporate insolvency law in Australia and the UK, is given by Justice Edelman of the High Court of Australia in his 2019 address ‘The evolution of bankruptcy and insolvency laws and the case of the deed of company arrangement’.

Winding up and realising the assets for these kinds of companies meant: 

• Auctioning plant and equipment
• Selling works-in-progress (for manufacturers) and inventory
• Collecting receivables
• Selling customer lists to competitors
• Selling other things that could be useful to competitors 

Businesses with this kind of asset profile still dominated the economy up until the 1980s when Australia’s main mechanism for formal debt restructuring, voluntary administration, was introduced by law.
 

The assets in a modern external administration

The Australian economy has changed significantly. Much manufacturing occurs offshore and service businesses (such as tourism, information technology, retail, transport, hospitality and financial services) are much more dominant in the economy. Service businesses primarily have intangible assets that are not easily split off and sold for profit. For example, the ‘know how’ that sits in a staff member’s head. There is greater total economic value in trying to preserve the business as a going concern, and little disadvantage to creditors who will receive little in a winding up anyway.

Creditors don’t receive much financial return from the winding up of a services business, not only because there are usually very little tangible assets on the balance sheet, but also because of financing. An added complexity is that where those tangibles, such as plant and property, exist, they tend to be leased or subject to a security before companies go into external administration. For example, a Purchase Money Security Interest (PMSI) is commonly held by creditors over the inventory of a debtor. 

It is also now common for businesses to get receivables finance, so even the money due from customers and clients is subject to a security interest and therefore out of the reach of the external administrator. This means that the external administrator, and therefore the creditors, don’t have the right to conduct a collect out of unpaid receivables. 

The end result is that insolvency practitioners appointed to service businesses usually get handed an empty balance sheet when they get appointed, or at least: 

• No plant and equipment because it is leased
• No receivables as they are held by a secured creditor or uncollectible because they relate to unfinished work
• No inventory as the supplier has registered a PMSI over it

In many cases the only asset on the balance sheet that is readily collectible is a director’s loan account (i.e. money that the director has drawn down from the business over time and must now pay back), and this will only be the case where the directors made the mistake of borrowing from the company rather than taking a wage/ salary. 

In recent doctoral research, Australian insolvency expert, Professor Jason Harris, observes that the re-organisation of the Australian economy towards service-based businesses means that their principal value now lies in intellectual property, human resources and service provision, instead of fixed assets. This means that, more than ever, there is a societal economic benefit in business turnaround and survival. Interestingly, these assets are not listed on the balance sheets of small-to-medium sized businesses in Australia and therefore are not recognised in most small-to-medium sized corporate insolvencies.  

Professor Harris also observes that the use of asset protection mechanisms, such as trading trusts, can also significantly reduce the assets that might otherwise be available for distribution to creditors in a winding up since the assets are not owned by the distressed company. This means that there is even more incentive towards a genuine restructure and business survival for this type of company because related entities that hold assets can utilise those assets even after the winding up of trading entities.

Does voluntary administration protect intangibles?

Voluntary administration was, until recently, the primary formal insolvency mechanism for debt restructuring. The voluntary administrator, an independent professional, is appointed to a company to attempt to come to a ‘Deed of Company Arrangement’ (DOCA) with the creditors. In theory, once restructured through a DOCA, the company could be returned to directors and continue to trade as before. 

A stay on enforcing ipso facto clauses for companies in voluntary administration offers some protection to distressed companies in order to allow space for a restructure. This prohibits suppliers, customers and other counter-parties from immediately ending contracts with companies that experience an insolvency event. 

Unfortunately, voluntary administrations have a very poor success rate in Australia. Two relevant features are:

• The directors lose control. While the voluntary administration is in progress it is the voluntary administrator, not the directors, that have control of the company. Voluntary administrators do not have the same incentive to keep the business ‘alive’ as directors do. 

• Voluntary administration damages goodwill. Given that the modern Australian company often holds few fixed and tangible assets, it is the goodwill and intellectual property – the company’s brand and ‘x factor’ – that needs to be protected. 

A voluntary administration has a chilling effect on goodwill and most creditors see it as the same as liquidation. 

It should be observed that voluntary administration is not designed for a small service business anyway. The intangibles are likely to be attached to the directors – they are the ones with the know-how and valuable customer relationships. A voluntary administrator cannot jump in and attempt to replicate that. After all, they are an accountant sitting in an office in the city without much knowledge of how to run a transport, retail or construction business. 

All these features make it tempting for business owners to attempt a ‘phoenix’. This involves selling the assets in the insolvent company (oldco) to a new company (newco) – a company that they also control – at less than market value. There is then a continuance of trading through the newco. This is particularly common in the construction industry. This activity is illegal and could constitute a ‘creditor-defeating disposition’ under the Corporations Act 2001 (Cth).

Does small business restructuring protect intangibles? 

Recently a new formal restructuring mechanism was introduced for small businesses. Insolvent businesses with debts under $1 million can appoint a small business restructuring practitioner to help develop a ‘restructuring plan’. If agreed to by a majority of creditors by value, the plan is approved, debts are extinguished and the business can continue trading. Read more about this mechanism in ‘A Complete Guide to the Small Business Restructuring Process’.

A core advantage of this process for small service businesses is that it might help them protect business goodwill. It is a ‘debtor-in-possession’ restructuring process, as is ‘Chapter 11’ in the US, which means that directors retain control of the company throughout. This makes it easier for the business to continue operating ‘as usual’ and also makes it less likely that customers/ clients will be scared off by suddenly dealing with the third-party accountant that is now in-charge of the business (the voluntary administrator).  

As it is a brand new process, it remains to be seen whether this will be the consequence.

It must also be noted that, as the mechanism is only available for smaller businesses, businesses outside the debt limit must consider other options. One mechanism that may still be available is a ‘pre-packaged insolvency arrangement’ (pre-pack), which transfers assets to a new company for fair market value. 

Conclusion 

The transformation of the Australian economy to one dominated by service businesses means there is extra incentive to turnaround, rather than break up, these businesses. As they have few fixed, tangible assets, there is very little left to sell for the purposes of creditor distribution. What these businesses have are intangible assets — their existing customer relationships, their people and their service provision — the value of which can only be preserved by turning the business around, usually via the business restructuring process.