Illegal Phoenixing - Can it be extinguished by law reform?

On 12 September 2017, the Turnbull Government announced proposed legislative reforms to address “illegal phoenixing” behaviour in an effort to “deter and disrupt core behaviours of phoenix operators”.

What is “Illegal Phoenixing”?

The Consultation Paper describes “illegal phoenixing” as “the stripping and transfer of assets from one company to another to avoid paying liabilities”.¹

Illegal phoenixing activities should be seen as distinct from “honest business rescue” efforts and are characterised by a company’s controlling directors exploiting the privilege of limited liability and acting in a manner which denies a company’s creditors' access to the company’s assets to meet unpaid debts.

Some commonly cited examples of illegal phoenix behaviours are said to include:

1. lodegment of Business Activity Statements (BAS) after the company becomes insolvent to obtain a refund of GST input credits.
2. non-payment of certain unsecured creditors.
3. non-payment or manipulation of employee entitlements including Superannuation Guarantee payments.
4. under declaration of staff numbers to state regulators in order to minimise costs associated with payroll tax and workers’ compensation.²

The proposed reforms also seek to target more sophisticated phoenix operators who set up complex corporate structures in order to place assets in certain entities whilst transferring liabilities into subsidiaries which can be subsequently placed into liquidation.³

What is being proposed?

The proposed reforms aim to deter and disrupt illegal phoenix activity and eliminate the detrimental effects that flow from it by addressing both those who engage in and those who facilitate the behaviour. This objective presents a delicate balancing act for the law-makers as they seek to minimise any unintended impacts on legitimate businesses.

The entire suite of reforms is too broad for all of them to be canvassed here, however, below are some of the more significant reforms being proposed.

PART 1 – Broad Reforms – Creating an offence of phoenixing

The central proposed reform is to create an offence of “phoenixing”, absent a current specific offence or a legislative framework that adequately addresses the behaviour.⁴

This reform has been the subject of a great deal of criticism, in particular the fact that illegal phoenix behaviour looks very similar to legitimate restructuring activities (most recently and notably the subject of the safe harbour reforms) and the problems that the law reform may have in delineating between the two.

The Government’s response to this was to seek to target the common illegal phoenix behaviour of transferring a company’s assets to a new entity, with the intention defeating the claims of creditors of the original company.  Specifically, the proposal is to amend the Corporations Act 2001 (Cth) to prohibit the transfer of property from one company to another if the sole purpose of that transfer was to “prevent, hinder or delay” that property becoming available for division among the first company’s creditors.⁵

The offence would give rise to a right for creditors and liquidators (and ASIC) to sue for compensation for the loss caused by the conduct.  Consistent with the stated over-arching objective of the reform package, this reform proposes to target both those who engage in the behaviour and those who encourage or facilitate it.

The commentary leads one to question why, for example, existing unreasonable director-related transaction offences are insufficient.

Promoter penalties

A further proposed reform is to bolster the “promoter penalty” regime so that it applies to facilitation of “illegal phoenixing”.

Any amendments will need ensure to that legitimate advisors carrying out honest business rescue or restructuring activities (again, as contemplated in the safe harbor reforms) are not caught in any expansion of the promoter penalty regime.  In response to this criticism, the Government has proposed that a defence be available to advisors in circumstances where advice is provided for legitimate purposes.⁶  No guidance has been provided on the metrics for legitimate purposes.

Extending director penalty notice regime to include GST

Under the law as it currently stands, unscrupulous directors are able to deliberately exploit the time-lag between collecting the GST and due date for payment to the ATO.  Company directors engaged in illegal phoenix activity can claim GST input tax credits for their costs and expenses, collect GST from customers and then liquidate the company without reporting the liability to the ATO thereby enabling them to retain the GST collected.

The proposal to target this type of behaviour involves expanding the existing Director Penalty regime to include GST.  Under the reform, if the behaviour is engaged in, then the director can be held personally liable to the equivalent amount of GST to the ATO.  The risk of personal financial penalty (and potential bankruptcy) is intended to serve as a financial disincentive.

PART 2 – Higher risk entities - Appointing liquidators on a “cab rank” basis

Of particular relevance to insolvency practitioners is the proposal to implement a cab-rank system in relation to the appointment of liquidators.

Whilst registered liquidators owe a fiduciary duties and have obligations to act ethically, professionally, independently, impartially and honestly, sometimes incentives are said to be provided (by a “rogue” director), by virtue of a relationship with an individual liquidator, for that liquidator not to act in accordance with those duties.

The selection of liquidators currently operates under an ad-hoc referral system.  Where a liquidator receives a large number of referrals from one source, there is said to be a potential for the independence of the liquidator to be compromised.  It is argued that the current referral model allows for dishonest liquidators to allow illegal phoenix activity to flourish.

The Government’s proposed response is to implement, in certain circumstances declared high risk, a “cab-rank” system whereby the usual referral system is dispensed with and replaced with a system of liquidators being appointed from a panel.  The aim is to provide directors with an independent liquidator to provide on the options available to the director.⁷

Lavan comment

Targeting offending phoenix behaviours, particularly given the costs to the economy, is welcome.  However, there is conjecture as to whether legislative reforms of the kind proposed are the answer and how they are reconciled in light of the recent innovation agenda reforms, in particular the safe harbour provisions.  Some have argued that rather than legislating, merely providing resources to increase the power and effectiveness of ASIC is a more appropriate response to illegal phoenix behaviour.  The results of the consultation process will provide an interesting insight into prevailing attitudes within the insolvency industry.