Using a voluntary liquidation for a section 510 debt restructure: the largely ignored creditor arrangements under voluntary liquidation
Company reorganisation or restructuring is the most common way of turning around a struggling business that is insolvent, or at risk of becoming so.
Table of contents:
- Different types of ‘debt restructure’ in Australia
- Small business debt restructuring
- An informal workout
- Pre-packs/safe harbour restructuring
- Voluntary administration
- Schemes of arrangement
- A section 510 arrangement
- What are the key elements of a section 510 arrangement?
- Evaluating section 510 arrangements
In this article, we focus on a little-known debt restructuring option under the Corporations Act 2001 (Cth) – a restructuring under section 510 of that Act, also known as a ‘section 510 arrangement’.
Different types of ‘debt restructure’ in Australia
Reorganisation or restructuring of the company means action taken to significantly modify the company financially or operationally, usually when the company is in financial distress. This might include asset sales, laying off staff, capital reorganisation and debt restructuring.
There are several different forms of debt restructuring that are permitted under Australian law. This article will consider each in turn.
Small business debt restructuring
In this process, insolvent companies with total debts of one million or less can appoint a ‘restructuring practitioner’ to develop a restructuring plan. While this is developed, the directors remain in control of the business and continue to trade as normal. If creditors agree to the plan, the debt is restructured and the business either continues on, or is liquidated/ wound up.
An informal workout
In a workout, the company attempts to get creditors to voluntarily agree to a restructuring of the debt. The debtor company could argue in some cases that this will maximise potential returns (as company assets are not eaten up in the appointment of an insolvency professional). In reality, this rarely works as there is no incentive for creditors ‘out of the money’ to agree to any restructuring plan. And if they don’t agree, they are not bound by it. If a company is actually insolvent, they won’t be able to try the informal workout approach (i.e. a private treaty with creditors) because they will be trading whilst insolvent.
Pre-packs/safe harbour restructuring
In a pre-packaged insolvency arrangement (‘pre-pack’), directors set up a new
company and sell the assets of the old company to the new company for fair market value. This arrangement is then signed off by a voluntary administrator or liquidator, and the old company is wound up. When arranged carefully, the development of this arrangement is legally permissible under the ‘safe harbour’ from insolvent trading in section 588GA of the Corporations Act 2001 (Cth). This section protects a director from liability for allowing insolvent trading where (among other conditions) that director “starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company”. On the other hand, if not undertaken properly it may constitute phoenix activity and the directors may become liable in subsequent legal action taken by a liquidator.
In this process, an independent professional is appointed by directors to take the reins of the company and attempts to arrive at a compromise, a ‘deed of company arrangement’ (DOCA), with creditors.
This mechanism has a relatively poor success rate and should generally be avoided by small businesses because it is too expensive to undertake.
Schemes of arrangement
The scheme of arrangement is a judicially-supervised restructuring process in Australia. Due to the timeframes and expense involved, these are usually only appropriate for very large company restructures.
A section 510 arrangement
This form of restructure is the focus of this article, and is discussed in detail below.
What are the key elements of a section 510 arrangement?
What will count as an ‘arrangement’ in section 510 is left completely open. However, the use of the term ‘arrangement’ does make it clear that this mechanism can include a reorganisation of the share capital of the company.
Concrete requirements for a section 510 arrangement in the Corporations Act 2001 (Cth) include:
- That the company be wound up, or be about to be wound up. So, in theory, this can be conducted immediately prior to liquidation.
- That a majority of creditors agree to it.
- That the company agrees to it via special resolution (i.e. 75 percent of shareholders agree to it). In essence, this gives shareholders a ‘veto’ power over any arrangement.
- That a copy of the arrangement is submitted to the Australian Securities & Investments Commission (ASIC) within 14 days of the resolution being passed.
While section 510 arrangements may seem somewhat similar to ‘schemes of arrangement’, no court supervision or approval is required throughout the process (though section 510 does provide an option for dissenting creditors to lodge an appeal with the Court).
Evaluating section 510 arrangements
Section 510 is rarely used. Presumably, this is because it occurs when the company is being wound up anyway (remember — liquidation must be either under way, or about to begin). This means there is little incentive for the company members to agree to the arrangement, given its timing, as it is unlikely to result in a better return than a straight-up asset sale through the winding up. This feature of section 510 arrangements is emphasised by Professor Jason Harris in his recent doctoral research, and in his article “Adjusting Creditor Rights Against Third Parties During Debt Restructuring”.
Other problems for a section 510 arrangement include:
- Winding up hurts a company’s reputation. Winding up is a public process and means the death of the company. Trying to restructure during a liquidation means restructuring at the point where the company’s reputation is already in the rubbish bin, and therefore asset value has dropped. Ideally, restructuring should occur when the company is still seen as a viable business proposition.
- There is no stay on secured creditor action. Generally speaking, during a small business debt restructuring or a voluntary administration a secured creditor cannot enforce their security interest (though, in most cases, they won’t be bound by a compromise without their consent). There is no such stay during a section 510 arrangement.
- Not corporate rescue. Professor Harris makes the point that this is not a genuine corporate rescue, but rather a way of one creditor group attempting to gain advantage, compared to its entitlements in liquidation. On the other hand, if any one director/ member has a majority vote, this could be a way to attempt to secure a greater share for themselves. Though, note, in that case, the arrangement is not binding on the liquidator. So, there is still the option for a liquidator to bring potential action against directors for unfair dealings (e.g. action for ‘unfair preferences’ or ‘unreasonable director-related transactions’).
Nearly always, turning an insolvent company around will mean debt restructuring. Australian insolvency law allows several options for doing so. One often overlooked option is a section 510 arrangement. While this is a flexible restructuring mechanism, as it only occurs when liquidation is occurring, or on the horizon, it is not often a feasible option for turning around a company, nor getting better outcomes for creditors.