The legal purpose of voluntary administration is to save insolvent businesses and, if that isn’t possible, to maximise the returns to creditors.
However, directors may choose to start a voluntary administration for other reasons such as to obtain time, to obtain control of a company or to frustrate investigations.
Provided that the company is actually insolvent (or about to become insolvent), it is legal for directors to appoint voluntary administrators for these strategic purposes.
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In Star Wars, both Jedi and the Sith manipulate the same ‘Force’. The Jedi appeal to the light side of the Force — to pursue good. The Sith appeal to the dark side — to achieve their own twisted goals. Australia’s core restructuring tool — voluntary administration — has this same duality. The voluntary administration process can be used by directors to save businesses or for an ulterior motive (as long as the company passes an insolvency test).
The purpose of voluntary administration in Australia is to rescue a struggling business and, where this is not possible, to get a better return for creditors than a straight winding up.
But what about directors who put their company into voluntary administration for other, more self-interested reasons? In this article, we explore the improper use of voluntary administration by dark side directors.
What are the proper purposes of voluntary administration?
Section 435A of the Corporations Act 2001 (Cth) sets out that the ‘objects’ of the part of that Act dealing with voluntary administration are to:
(a) maximise the chance of business surviving, or
(b) failing that, achieve a better result for creditors and members (shareholders) than the immediate winding up of the company.
But the Corporations Act 2001 (Cth) does not explicitly state that directors need to have these objects in mind when they appoint a voluntary administrator. These objectives guide the courts in regulating voluntary administration matters and the insolvency practitioners appointed.
The only explicit precondition for a voluntary administration is stated in section 436A. It is a requirement that, in the opinion of the directors voting for a resolution (to appoint a voluntary administrator), the company is insolvent, or is likely to become insolvent at some future time, and that a voluntary administrator should be appointed. This may create an agency problem, that directors will be motivated to make the appointment because it favours them. The question then arises – so what? Isn’t business about self-interest after all and don’t we need highly motivated business people to work hard to create economic growth?
While section 436A makes it clear that voluntary administration is optional, many larger companies in Australia end up ‘forced’ into voluntary administration by the ease of taking this step, relative to initiating a voluntary liquidation. As stated above, only a board resolution is required to appoint a voluntary administrator.
By contrast, to initiate a voluntary winding up of an insolvent company, a special resolution (75 percent majority) of the members (shareholders) is required. This means that if shareholders can’t agree to liquidation, appointing a voluntary administrator is a risk mitigation step for directors who could otherwise be accused of allowing the company to trade while insolvent.
It is a little easier for SMEs in Australia, as they have access to the simplified liquidation and small business restructuring procedures in the Corporations Act 2001 (Cth), as alternatives to voluntary administration.
Here our focus is on what happens where directors pursue voluntary administration, not in line with the objects set out in the Corporations Act 2001 (Cth), but in line with their own self-interest.
For more information on the voluntary administration process read our long article: The Complete Guide to Voluntary Administration.
What might count as an improper purpose for voluntary administration?
What counts as an improper purpose, or an ‘abuse’ of voluntary administration? Clearly, it must be a case where directors are not motivated by turning around the company or by obtaining fairer returns for creditors. It is these improper purposes that are sometimes pushed by pre-insolvency advisors prior to an insolvency process being initiated, such as phoenix activity.
Intan Eow in “The Door to Reorganisation: Strategic Behaviour or Abuse of Voluntary Administration?”, stated it in the following way: “Put metaphorically, it is an abuse if the debtor reorganises only to carve the pie up differently without enlarging or preserving the pie.”
So what are some examples of purposes or motivations for voluntary administration that might count as an abuse by this definition?
Eow considers several examples of nefarious intentions based on a survey of the case law:
- To delay creditors. As creditors cannot pursue legal action for recovery of their debt while voluntary administration is in play, directors may use it to ‘buy time’. Similarly, it can be used to avoid paying outstanding employee entitlements (while the voluntary administration is in force).
- To frustrate litigation. The appointment of a voluntary administrator doesn’t just stay a winding up petition, it stays nearly all legal proceedings against the company (exceptions include criminal proceedings). Therefore, appointing a voluntary administrator is sometimes a trick used by companies to stop litigation that has commenced or is about to do so. Relatedly, voluntary administration can be used to frustrate potential future claimants. Those who may have a future claim, but are not in a position yet to bring litigation, can find themselves locked out of negotiations while, in effect, the company’s assets are being ‘carved up’.
- To gain control of the company. Potentially, directors could be aiming for a capital restructuring of the company in their favour (i.e. giving them a larger chunk of shares in the company through a debt for equity swap in a Deed of Company Arrangement (‘DOCA’)). As shareholder disputes are common, a DOCA could be a useful mechanism for pushing out non-cooperative directors – it could avoid litigation between directors.
In recent doctoral research, Professor Jason Harris points out some other possible improper motives:
- Attempting to frustrate the investigation of director conduct. While voluntary administrators can investigate director conduct and report to the Australian Securities & Investments Commission (ASIC) on their findings, they don’t have the same incentive as a liquidator. This is because the liquidator can bring unfair preference claims and unreasonable director-related transaction claims to claw back assets into the pool for distribution to creditors. So uncovering director misconduct can be an important part of growing the pool of assets. Note, if no DOCA is agreed, the company will be liquidated and the directors investigated by the liquidator anyway.
- To change the operation of the relation-back period. The ‘relation-back day’ is the date from which transactions entered into by the insolvent company can be considered void. Previously, it was possible for directors to appoint a voluntary administrator in order to create a ‘new start date’ for the relation-back period and exempt some of their transactions from scrutiny (see, for example, St Leonards Property Pty Ltd v Ambridge Investments Pty Ltd (2004) NSWSC 85). However, an amendment to the Corporations Act 2001 (Cth), in force from early 2017 (see section 91), means that this loophole has been largely closed.
What do directors need to do to properly appoint a voluntary administrator?
It is settled case law that in order to comply with section 436A, it is essential that the directors have:
- a genuine belief that the company is insolvent or likely to become so, and
- a belief that is reasonable (see, for example, Downey v Crawford  FCA 1264).
This means that ‘wilful blindness’ as to the company’s accounts is not enough. Nor is the absence of recordkeeping. To satisfy this requirement, directors need to have conducted at least a preliminary investigation into the company’s insolvency and formed a view based on the evidence found.
In many cases where directors appear to have abused voluntary administration, the courts have found that they have not satisfied the requirement in section 436A.
Nevertheless, isn’t it possible that directors could meet this test and still initiate voluntary administration for the wrong reason? After all, section 436A is about when directors may initiate the process, not when they must do so.
Section 447A of the Corporations Act 2001 (Cth) gives the court extremely wide powers to end a voluntary administration, including where it is of the view that “provisions of this Part are being abused” or “for some other reason”. In short, the court will always be able to overturn a voluntary administrator appointment where it is convinced that the appointment has happened contrary to the objects of that Part of the Act. Having made this observation, this is very unlikely in the event that the company was actually insolvent at the date of appointment. If the company entered into a deed of company arrangement that was prejudicial to some of the creditors, then the creditors could apply to the court to reverse that debt compromise as a separate matter.
The purpose of voluntary administration is clear — to turn a company around or, failing that, achieve a better outcome for creditors than immediate winding up. Dark-side directors who initiate voluntary administration for other reasons can have that action terminated by the courts, as well as being subject to potential penalties and costs. Having pointed out that directors may choose to appoint a voluntary administrator for an ulterior motive, this is not in itself illegal (so long as the company was insolvent) and it may constitute strategic rather than abusive behaviour by the directors.
Questions and answers about VA
In contrast to voluntary administration, a business will generally cease to trade when it goes into voluntary liquidation. The purpose of liquidation is to put the company into the hands of a liquidator who realizes all the assets of the company and also undertakes investigations and reporting to creditors.
It is rare that a liquidator will allow a company to continue trade once it has been placed into liquidation but they may do so in circumstances where they do not have any personal risk from continued trading and there is a good reason to allow a business to continue trading.
When a company goes into voluntary administration, there is a general moratorium on the enforcement of creditor claims. There are some exceptions, but the moratorium applies to all unsecured claims (i.e. bare debt claims where the creditor does not have any rights to collateral).
The moratorium usually means that creditors will be limited to participating in the voluntary administration process and any returns will only be derived from a deed fund (through a deed of company arrangement) or, if the company goes into liquidation, through any dividend that ends up being paid to creditors at the end of the liquidation process.
There is a low chance (overall) that either a deed fund or a liquidation process will deliver a substantial return to unsecured creditors; however, there are exceptions. A substantial return to creditors would occur when unsecured creditors receive more than 20% of the face value of their debt.
The two key stakeholders in a voluntary administration are the existing owners/management and creditors. The key disadvantage for existing owners/management is that they lose control of the business when they appoint a voluntary administrator.
The administrator then has a discretionary decision about whether to allow the business to continue to trade and whether to support a compromise proposal (through a deed of company arrangement).
The key disadvantage for creditors occurs when a business is not viable and the directors do not intend to put money towards a deed of company arrangement. In these circumstances it is likely that a voluntary administration will progress to a liquidation and that the overall costs of the external administration process will be higher. That will be likely to reduce the returns to creditors due to the double-up of a voluntary administration process and a liquidation process.