- Our Client, Tom, hails from Ireland and is a drilling industry insider with more than 40 years of experience. But after riding the boom of mining services in the noughties, his business collapsed when key contracts with big miners dried up in 2013.
- Tom put his companies into voluntary administration to develop a restructuring plan (a DOCA) but this action was defeated when his bank appointed receivers – who sold off everything through a fire sale at the worst possible time in the market cycle.
- The hard lessons that Tom discussed with us in preparing this case study included:
- Procrastination: When the downturn in the mining industry started he regretted not radically reducing overheads by laying off staff.
- Deterioration: By not radically reducing overheads, Tom utilised a bank overdraft that became unsustainable.
- Supporters: He should have hired a good insolvency lawyer and a turnaround accountant to prepare a proposal for his bank because his employee accountant didn’t take any decisive action when it was required.
- Alternative plan: If he persuaded the bank to give him more time, he could have sold a subsidiary business for $15m and given himself a couple of years to rebuild his business.
- Fire sale: Allowing the receivers and voluntary administrator to run a fire sale process resulted in the complete liquidation of the business at the worst time in the market cycle.
- By the time Sewell & Kettle Lawyers were engaged there were no assets in the liquidated business but Tom owed a personal debt to his bank of $8.4 million that represented a shortfall on the receiver’s recoveries towards the bank debt.
- How we saved Tom’s shirt: Sewell & Kettle negotiated with Tom’s personal guarantee creditors for debt forgiveness and we obtained a complete debt forgiveness from his bank so Tom avoided personal bankruptcy. He kept his shirt but lost his business.
Client’s background and business
The human side of this case study is that our client, Tom, is a down-to-earth and hardworking mining driller with a positive view about life. Tom has a growth mindset and enormous experience as a professional driller (>40 years). We loved having Tom as a client because he has a good sense of humour and he shares our values.
Tom started his first drilling business in 1976 and he successfully sold it in 1998. He started another business in 2005 that is the subject of this case study but this business eventually went into voluntary administration (and was then liquidated in 2014). His business was positioned in the market as a subcontractor to large miners and it operated its large drilling rigs all around Australia.
Tom’s 2005 business, considering that it started from scratch, was a raging success. It grew to have a total turnover of $74 million and about 255 staff. But the business also bore the economic risk of large miners and when those miners reduced their operations Tom would be caught out with high fixed overheads and insufficient turnover to support the business. In retrospect, rather than applying a positive mindset, if he applied a hard-headed and pessimistic view about future cash flow projections it would have put Tom in a better financial position.
The key assets of the business were its people and plant and equipment (predominantly drilling rigs). People don’t sit on a balance sheet (thank goodness) so they can’t be sold by company receivers – only fired. Because the drilling industry is generally transient, subcontractor businesses (like Tom’s) are usually valued as goodwill free. If they collapse the fire sale process would therefore be likely to be plant and equipment only with little interest from third parties in purchasing the business on a going concern basis. Tom did have one subsidiary business with dependable recurring income that ended up being sold by his company’s receivers.
Who did Tom have to help him deal with his crisis when the key contracts dried up? He relied upon two employees, a manager and an internal accountant. His key manager didn’t have any experience working on turnarounds and sometimes had a toxic effect on those around him. Tom’s internal accountant (an employee, not his external public accountant) also had no experience in turnarounds and before a key meeting with the bank, he didn’t prepare any pertinent financial analysis that could have helped Tom to deal with the bank. For example, it would have been useful to provide the bank with a comparison between workout (i.e. a turnaround with the support of the bank) and liquidation scenarios. In summary, both of his senior managers were completely out of their depth.
When he reflected on Day 1 of his crisis Tom told us: “In retrospect I should have retrenched everyone”. Why? Because in 2013 when his key contracts weren’t renewed by the big miners his business overheads had very quickly become unsustainable. Subcontractors bear the risk of changes in market cycles because their clients hire them only on a job-by-job basis without any long term guarantee of recurring income. The staff wages that were being paid during the downturn ended up being financed through Tom’s bank overdraft.
Would it have been possible for Tom to retrench the staff or even consider standing them down? The answer is yes, but that wouldn’t have been the path of least resistance.
So what did Tom end up doing? Tom told us: “I ended up paying my staff for a year and making a big loss. It wasn’t worth all the pain that I went through given the risk. I was also probably the lowest paid person in the company.”
We find that business owners during a financial crisis typically don’t pay themselves an appropriate salary before their business collapses. They end up investing sweat capital without any appropriate financial return – this is at a time when any other employee not getting paid would result in allegations of “wage theft”!
Another typical issue that we see is an investment in a big project that fails. This big project drains working capital from the business and it is often aimless. Tom had stretched his business to move into drilling operations in Africa and this included a joint venture in Mauritania. This new business investment turned sour when the Mauritanian tax authorities impounded company equipment and started a tax audit. This project became completely unsustainable when it got stuck in the quicksand of dodgy third world tax collectors and expectations that foreigners must “oil the wheels” of bureaucracy to succeed.
The final precipitant of the collapse was the failure of a key miner to renew the largest contract that the business had – a contract that generated $4m / month in revenue.
From our perspective there are a number of causes of business insolvency that one can list from the case study:
- Inadequate management personnel
- Loss of a key client
- Investment in a poorly planned big project that failed
- Inadequate accounting analysis
- Fast growth without adequate working capital (growing broke)
These five factors made Tom’s business particularly fragile to the economic shock of the downturn in the mining industry.
What were the causes of Tom’s business insolvency?
- Inadequate management personnel
- Loss of a key client
- Investment in a poorly planned big project that failed
- Inadequate accounting analysis
- Fast growth without adequate working capital (growing broke)
Failed rescue of the business through voluntary administration
So what tools and legal processes did Tom have to deal with his cash flow crisis? The Australian corporate insolvency regime is a creditor-in-possession system and this means that the directors don’t continue to manage their business when they put their company into voluntary administration. The voluntary administrator calls the shots and is likely to close the business down shortly after their appointment. Unlike Chapter 11 in the United States business management can’t apply to court for 180 days of bankruptcy protection whilst they develop a restructuring plan. Most of the time voluntary administration in Australia doesn’t work, and please note that this isn’t the fault of the insolvency practitioner, it’s because the system doesn’t give the benefit of the doubt to the directors.
Before Tom decided to appoint voluntary administrators (he was the sole director of all the companies that made up the business) he had only two meetings with them. He also didn’t get much support from his internal accountant about how to evaluate the prospects of voluntary administration. During these preliminary meetings the insolvency practitioners advised that a deed of company arrangement proposal was the best way forward but did not undertake any due diligence (other than speaking to the client’s bank) to test the prospects of this restructuring tactic. This isn’t unusual because insolvency practitioners are required to maintain independence by law so they can’t get into the nuts and bolts of a troubled business and then accept an appointment as voluntary administrator. The writer doesn’t agree with this legal policy but it is currently the law in Australia and it doesn’t look like it will change. Insolvency practitioners, if they choose to, should be allowed to undertake due diligence into companies before they are appointed and give meaningful advice.
So what did the insolvency practitioners propose? Basically – to try and trim down the business to create a smaller business that was going to be able to trade successfully going forward. The insolvency practitioner, to their credit, did advise Tom that the bank would need to agree to a deed of company arrangement proposal and that would require some debt forgiveness on their part. On the other hand, if Tom had received good turnaround advice he could have tried this himself for a fraction of the cost and without the chilling effect of a voluntary administration. Voluntary administration has a chilling effect because market players see it as the equivalent of a liquidation.
So why wouldn’t the bank agree to debt forgiveness? Wouldn’t a successful turnaround increase the bank’s chances of full repayment? The key issue is that Tom and the insolvency practitioners knew about the General Security Interest over all property held by the companies, the All-PAAP. This security interest (once called a fixed and floating charge) gives the bank the right to appoint receivers and take over the business when there is an event of default on the repayment of their facility. The appointment of voluntary administrators was one such event of default that the bank could use to appoint receivers. Unlike in the 1980s (when Australian banks would trigger receiverships more readily) banks want to protect their reputation by not appointing receivers unless it is necessary or, in our experience, if the bank staff get peeved off or suspicious.
How did the meeting to discuss restructuring with the bank turn out? The meeting with the bank turned out to be very important. Tom and his internal accountant met with the bank and at the meeting there was an insolvency practitioner from the bank’s panel there too. This should have been a red flag to Tom given that the bank subsequently appointed that insolvency practitioner to be the receiver of his business. This turned out to be the only time that Tom met with the bank before he appointed voluntary administrators. Tom, mistakenly, treated the meeting as an opportunity to make a bargain whereas the bank treated this as an opportunity to test him about the quality of his turnaround proposal.
Tom said to the bank officer: “We’re in serious trouble – what would the bank take? Would you take 50c in the dollar?
Bank officer: “That’s not how we work – we can’t give you an answer”.
Tom remembers leaving the meeting with the bank officer believing that the bank wouldn’t appoint a receiver and that they would monitor the voluntary administration carefully and give it a decent chance of success. Tom’s view was naïve and although the bank didn’t say that they would appoint a receiver they were guarded in their dealings with Tom. This meeting, however, may have been the kiss of death for Tom’s plan to restructure the business through a voluntary administration because the bank didn’t feel at all comfortable with the process that Tom was proposing. No one from the bank was going to horse trade at the meeting or commit to anything without objective analysis. One should expect that a bank is going to protect its balance sheet first and that the business owner has the primary responsibility for driving a turnaround and convincing the bank that it is in its interests to support this turnaround.
What did Tom do wrong at the meeting with the bank?
- Tom didn’t have an insolvency lawyer or turnaround practitioner who knew the players and what was expected to be done. He needed someone experienced to talk to the bank and the insolvency practitioners doing investigation work for the bank. Tom relied on an internal accountant who didn’t properly prepare for the meeting. This was a key mistake – because he should have had a good advocate in his corner. Tom’s internal accountant didn’t prepare a written proposal to put to the bank and, in retrospect, this would have been critical. The types of financial analysis that the bank expected would be plant and equipment values, anticipated cash flows for the next 12 months, a comparison of liquidation and turnaround scenarios, etc.
- Tom didn’t do his own due diligence about the market value of his plant and equipment versus his bank overdraft at the time of the appointment of the voluntary administrators. It could have been possible to retrench staff and then sell some plant and equipment to pay off part of the overdraft and negotiate with the bank for a year’s grace to work out of the financial stress. But he left this too late. The receivers were able to sell one of his subsidiaries for $15m and that in itself should have kept the bank facility funded for some time.
- Tom didn’t get any commitments or buy-in from the bank. And to be frank – why should they? Tom didn’t take them anything by way of a plan that they could work with.
The result of the voluntary administration of the business was a catastrophe for Tom. The trading entities of the business went into voluntary administration shortly after the bank meeting and then the bank immediately appointed a receiver to sell off the plant and equipment that it had financed. This meant that there were two top tier insolvency firms working on the same external administration and their professional costs were enormous. It also meant that the business had no drilling rigs to operate and therefore it quickly became an empty shell with a lot of debt.
Tom believed that the appointment of receivers “pulled the rug out” from the voluntary administration process because without plant and equipment the voluntary administrator couldn’t operate the business. On the other hand, the bank must have formed the view that it would get a larger and/or faster return through a receivership than supporting a DOCA. Why shouldn’t the bank take a cost/benefit approach to the problem? The voluntary administration became pointless without any drilling equipment and so there was no prospects of a debt restructure that could have saved part of the business and also jobs.
In the final report to creditors the voluntary administrators recommended that they should put the trading company into liquidation and at the second meeting of creditors the company was wound up. This meant the business was a goner.
Once the receivers had finished their job there was a shortfall owed to the bank and this debt was within the scope of a personal guarantee signed by both Tom and his wife (a shareholder but not a director of the business). The sword of personal bankruptcy hung above Tom and this would have resulted in the loss of his home and other assets that he held in his own name.
Tom on his response to the crisis:
“In hindsight I would have retrenched almost all of the staff after we lost the Xstrata contract. Kept a single accountant. The large miners have all the resources and we really relied on them to get back to work. We needed time to wait until they would come knocking again with more contracts. I should have sold some assets to keep the bank happy including the subsidiary that had regular cash flows. I think that I got a large overdraft too easily and then the bank wouldn’t agree to a haircut of its debt. No one told me this was how it could pan out and I really needed better lawyers and accountants who represented me. I can’t blame the voluntary administrators or the bank – they have their own businesses to take care of.”
Liquidation scenario unfolds
The result of the receivership and the liquidation was the closure of the business, the termination of all staff and the public auction sale of all plant and equipment.
The equipment was sold at the trough of the market cycle for low prices. For example, Tom said that one of the drilling rigs was sold for $400,000 and that today the same machine would be valued at around $1.6 million. This sale price is not the fault of the receivers – their job was to sell the equipment for the best price they can obtain at the time of sale. It was just the worst time to sell.
The liquidation process took a couple of years to complete and the liquidators (the former voluntary administrators) were largely funded through the recovery of an unfair preference claim that was paid by the ATO. There was no legal action undertaken by the liquidators against the client for anything (such as insolvent trading or any other breach of director’s duties) so there are no allegations of any wrongdoing against Tom.
With the completion of the liquidation there were still bills to be paid. The key issue that Tom faced was that creditors had signed personal guarantees from him and the bank had also obtained a signed personal guarantee from his wife. This became a matter of concern for Tom because the bank could claim all of its costs and interest (including receiver’s fees) that made up a shortfall on their secured debt.
The unsecured creditors of the liquidated companies did not receive a dividend and the employees all lost their jobs. No one tried to buy the drilling business and the only party that received a decent return was Tom’s bank through the auction of plant and equipment and the sale of a subsidiary business.
In retrospect the bank wasn’t too ruthless but managed to be largely successful in maximising their recovery. It obtained a recovery of a large part of its debt via asset sales. It sold all the plant and equipment and although the receivers tried, they couldn’t sell the drilling business itself. The receivers did manage to sell a subsidiary for $15m as a going concern sale. In retrospect, if Tom had been able to sell this subsidiary himself it could have been enough to keep everything else afloat for a couple of years. But – that would have also required radical reductions in overheads and the development of a turnaround plan that the bank supported.
Sensible asset protection strategies undertaken that helped Tom
Tom did have a good personal asset protection structure in place that preserved most of the wealth he had saved. In 1981 Tom started a superannuation fund (before it was compulsory to contribute to a super fund) and he was therefore an early adopter of the SMSF. Tom’s superannuation fund became the principal entity that held real estate and other investments for Tom and his wife (other than their residence). The best part about superannuation in Australia is that it is usually insulated against personal bankruptcy.
On the other hand, the key weakness in the client’s asset protection strategy was that he owned half of his residential property with his wife owning the other share and they had both signed personal guarantees with the bank. This put them in the firing line to be personally insolvent for the shortfall in the bank’s return on the loan and lose their home too.
It’s also pertinent to point out that Tom was a good businessman and employer. That is important for asset protection purposes because of all the regulations that allow the corporate veil to be pierced for employee, environmental or management problems. There was no suggestion of any fraud or improper transactions undertaken prior to the insolvency of the business by the liquidators or receivers and this must have contributed to the commercial position of the bank when it agreed to substantial debt forgiveness at the conclusion of the matter.
Should a business owner get professional advice on asset protection?
Answer: Yes, (if you haven’t already done so) get a lawyer or accountant to analyse your existing structure and work on separating your trading risk and personal assets. Consider superannuation, family trusts, loan agreements and personal guarantees, shareholder agreements and areas where the corporate veil can be pierced. Asset protection structures need to be put in place before you are actually insolvent or it can be reversed.
Challenges faced before Sewell & Kettle Lawyers were engaged
Sewell & Kettle was engaged late in the process – after the assets had been collected and realised by the receivers and when it became obvious that there was going to be a large shortfall on the bank’s security.
Sewell & Kettle was engaged after the receivership had completed so the firm had to ‘get up to speed’ quickly about the scenario and the personal bankruptcy risk that our client faced. There were equipment financiers with large debts that were also personally guaranteed but the most important creditor was Tom’s bank.
Although the client had most of his assets in a superannuation fund (due to prudent asset protection advice obtained a long time before the insolvency of his business) he and his wife faced losing their home and other assets that weren’t held in the super fund. Tom also wanted to keep working and bankruptcy would have stopped him for being a company director or taking on a management role. This would have crippled Tom’s future earnings prospects for the three year period of undischarged bankruptcy.
How Sewell & Kettle Lawyers helped
The first step was to get to know the client’s circumstances and then engage in discussion about strategy. After we got a handle on the situation our client instructed us that their goal was to avoid personal bankruptcy.
We looked at a Personal Insolvency Agreement (Part X of the Bankruptcy Act) as a potential solution but the client decided to see what he could obtain via a negotiation with creditors (a private treaty) first. In Australia PIAs have been seen as a bit dodgy in the last decade and so the procedure isn’t used as much as in the recent past. It requires a 75% favourable vote from creditors so the bank would have had a veto on that PIA process anyway if it didn’t want to agree.
We corresponded with creditors and liaised with the solicitors acting for the bank with the objective of stabilising the situation and putting into place an orderly process so that creditors didn’t feel it necessarily urgent to proceed with a bankruptcy court action. No creditor ended up starting a bankruptcy proceeding so the matter concluded as a private treaty.
The bank, due to the co-operation it received from Tom in its receivership, eventually decided to forgive the debt owed for a fraction of its face value. This represented an enormous win for the client and an excellent outcome from our firm. The client refinanced his residential mortgage with the bank and the bank’s equity position in this real asset was clarified.
Lessons learned by the client and takeaways for mining services subcontractors
- Pay yourself a salary: We have clients who invest significant sweat capital in a business that is in decline and they fail to pay themselves a salary. If you are the business owner it is prudent to pay yourself a salary during both good times and bad times.
- Personal guarantees: Remember to avoid STDs (sexually transmitted debt) so don’t allow your wife to become a company director and sign personal guarantees for creditors. It would be better to insulate her from your business.
- Dealing with creditors: Take a sensible course of action with the creditors because they may choose to make a commercial decision to forgive debt if they are satisfied they won’t get a better outcome through bankruptcy and they don’t want to punish you. If you don’t have the money to pay them, tell them rather than ghost them.
- SMSFs: A superannuation fund is an excellent asset protection instrument because it is usually protected from bankruptcy.
- Bait and switch tactics from professional advisers: Be careful of bait and switch tactics from professional advisers – if you are advised that voluntary administration is the best option (rather than a safe harbour restructure) consider the quality of the due diligence it is based upon. In this case study the voluntary administrators advised that voluntary administration was the best option to save the business without conducting any due diligence. The problem was that no one else did due diligence and our client didn’t realise that the voluntary administrators were actually legally prohibited from doing due diligence on the prospects of a VA process themselves so it was actually his responsibility to evaluate voluntary administration.
- Use offshore corporations for overseas contracts: The client made the mistake of using Australian companies for overseas contracts – he should have considered creating offshore entities to insulate the Australian companies and vice versa. Why not use corporate structuring overseas better? The answer is that accountants in Australia aren’t comfortable with this so they don’t suggest it to clients.
- Exit strategy: Tom didn’t have an exit strategy for his business. There wasn’t anyone in his business that had enough nous to take it over and it is difficult to sell a mining subcontractor. There is no easy answer to how subcontractors can develop an exit strategy but given the sweat capital they invest in their business and the risks they take it is a critical issue for their future. One credible suggestion is that the business owner explores “half-retiring” a few years before actual retirement and focuses on a sale process as a project.