Insolvency law reform in Australia: Big benefit for small and medium enterprises?

Introduction

The COVID-19 pandemic has proven to be a prominent opportunity for reform of national corporate restructuring frameworks around the globe. In the Fourth Quarter 2020 edition of our International Restructuring Newswire, we examined the new developments in a number of the tools available for financial restructurings in the United Kingdom, Germany and the Netherlands (all of which were designed to incorporate some of the benefits of restructuring available under Chapter 11 in the United States). In this issue, we turn our attention to Australia and discuss the proposed changes to its restructuring laws, which were introduced in January 2021.

The Corporations Amendment (Corporation Insolvency Reforms) Act 2020 (Cth) (Legislation) represents the most significant reform to Australia’s corporate insolvency regime in almost 30 years, and is the latest in a series of measures introduced in response to the economic impact of the pandemic. The main objective of the Legislation is to help small and medium enterprises (SMEs) in Australia overcome the economic, financial and operational challenges caused by the pandemic. The reforms also recognise that, for a variety of reasons, the current insolvency processes in Australia have become compromised or impractical in the SME space.

The Legislation centres on the introduction of two new restructuring and insolvency processes for SMEs, and consist of:  

1. a simplified debtor-in-possession restructuring process

    

2. a simplified liquidation pathway

    

3. additional “complementary measures” aimed at increasing the number of insolvency practitioners available to regulate the new processes

The new restructuring process draws on some debtor-in-possession aspects of Chapter 11 of the US Bankruptcy Code, and introduces a new process for eligible businesses to work with specialist restructuring practitioners to restructure existing liabilities under a restructuring plan approved by creditors.

The Legislation, which establishes the framework for the insolvency reforms, has been available for eligible small businesses since 1 January 2021. The details governing the operation of the new simplified processes have been included in subordinate legislation. The regulations to the Legislation were released on 21 December 2020 (Regulations) and the rules were released on 22 December 2020 (Rules), just ten days before the new processes were enlivened.

Context

When law reform is proposed, it is important to first look at the context in which the new laws are being introduced. In the case of Australia, there are two key factors which have led to the reforms (i) the SME market and its importance to the Australian economy, and (ii) the existing legal framework and its preparedness and ability to deal with the disruption caused by the pandemic.

SMEs play a significant role in the Australian economy, and so it is important that Australia has strong SME insolvency laws. To this end, it is worth noting that:

• 97.5% of businesses in Australia employ less than 20 employees (i.e. are small businesses).

   

• Small businesses employ 4.7 million people in Australia, representing 44% of the total number of people employed in the private, non-financial sector.

   

• SMEs have been particularly badly affected by the pandemic.

As a result of the pandemic, many SMEs will need to restructure both operationally and financially and others will cease to exist entirely. Accordingly, it is no surprise that the Australian Government has focused the proposed insolvency law reforms on the SME sector.

While the decision to enact the Legislation in Australia was triggered by the pandemic, there has long been pressure on the Australian Government to reform the “one size fits all” approach to insolvency law in Australia. The existing formal rescue process for insolvent companies in Australia is voluntary administration under Part 5.3A of the Corporations Act 2001 (Cth) (Corporations Act), which involves the approval and implementation of a deed of company arrangement (DOCA). The voluntary administration process takes a “one size fits all” approach to financial distress, subjecting an insolvent café to exactly the same regime and processes as were recently applied to the insolvency of Virgin Australia.

Accordingly, the existing insolvency processes in Australia are criticised as being too expensive and complex for SMEs, and these criticisms are exemplified by the most recent annual corporate insolvency statistics published by the Australian Securities and Investments Commission (ASIC), as follows: 

• SMEs dominate external administrators’ reports.

   

• 85% of businesses entering into external administration had assets of AUD $100,000 or less, 76% had fewer than 20 employees and 38% had liabilities of AUD $250,000 or less.

   

• 96% of creditors in this group received a dividend between 0–11 cents in the dollar (as an outcome of the external administration), reflecting the asset/liability profile of SME insolvencies.

Overview of the Legislation

Restructuring process

In a limited sense, the “restructuring” process is derived from Chapter 11 of the US Bankruptcy Code. It is intended to provide “financially distressed but viable” small businesses with a “simple, cheap and faster” method of restructuring their debt than the existing regime. 

The new process sees the introduction of the debtor-in-possession model into Australian insolvency law, with business owners continuing to operate the business under a moratorium whilst they develop a restructuring plan with the assistance of (and, ultimately, certification by) an independent “small business restructuring practitioner” (SBRP). The restructuring plan is then put to the company’s creditors (within 20 business days) and voted on by them (within a further 15 business days). The company must pay its employee entitlements before the creditor vote.

To address the time needed for practitioners to become familiar with the new process and register, the Legislation will also include a transitional process. This will enable a company to declare its intention to access the process, which will act to extend the existing insolvency relief to that company for up to three months to enable a practitioner to be engaged.

Simplified liquidation pathway

The “simplified liquidation pathway” is a streamlined version of the existing Australian liquidation process. The key differential is the reduction of the statutory obligations imposed upon the liquidator for “straightforward” liquidations of small businesses without evidence of director misconduct. 

These include:

• reducing the circumstances in which a liquidator can recover unfair preferences from unrelated creditors
• removing the obligation to report on misconduct unless there are reasonable grounds to believe misconduct has occurred
• removing requirements to call creditor meetings
• simplifying the dividend and proof of debt procedures 

The measures are intended to reduce the costs associated with the administration of the liquidation process for small companies (which can impose an administrative burden without commensurate benefit to creditors). The intention of the new process is that it will increase the dividends paid to creditors of small businesses.

In recognition of the potential for misuse, each of the processes will include “safeguards”, which include:

• in both processes:
  • administration by an independent practitioner
  • the preservation of the rights of key creditors, e.g. secured creditors with ‘all asset’ security
  • a bar on the same company or directors using the process in a seven year period
• in the restructuring process:
  • a power for the practitioner to stop the process if misconduct is identified
  • the right of creditors to vote on the proposed restructuring plan
• in the liquidation process:
  • the power for creditors to convert the liquidation to a “full” liquidation process
  • the obligation for company directors seeking to use the process to declare the company is eligible and has not engaged in illegal ‘phoenixing’ activity

Complementary measures

To deal with the expected increase in the number of businesses that may seek to use the new processes, the legislation will also include incentives designed to increase the availability of practitioners to take appointments. 

These include:

• temporarily waiving registration fees for registered liquidators until 30 June 2022 in order to encourage practitioners to enter or re-enter the market
• changes designed to allow greater flexibility in the registration of insolvency practitioners
• introducing a new class of practitioner who will be limited to the new restructuring process only.

Comparison with the US and the UK

The Legislation bears resemblance to similar provisions recently introduced in the US and the UK. In the US, the Small Business Reorganization Act 2019 (US) (SBRA) was enacted in August 2019 and took effect in February 2020.

The SBRA added a new Subchapter V to Chapter 11 of the US Bankruptcy Code to address deficiencies identified in the existing process for SMEs, including high costs, monitoring deficits, and procedural roadblocks.

A key distinction between the new restructuring process in Australia and Subchapter V is the eligibility requirements, with the requirements being much more restrictive in Australia.

In summary:

• Only incorporated Australian businesses will be able to access relief under the new restructuring process, whereas any business is eligible to file for Subchapter V (so long as 50% of their liabilities constitute business debt).

   

• The new measures in Australia are only available to SMEs with liabilities of less than AUD $1m (which the Australian Government states represents 76% of businesses subject to insolvency today); in comparison, Subchapter V initially had a debt ceiling of USD $2.7m (approx. AUD $3.8m), however the US Congress increased Subchapter V’s eligibility threshold to USD $7.5m (approx. AUD $10.6m) in response to the projected increased demand caused by the pandemic.

   

• Related-party loans do not count towards Subchapter V’s debt cap, which may be significant in the current economic climate; it appears from the Regulations that related-party debt will count towards the AUD $1m threshold in Australia.

The Legislation is not a full-scale adoption of all the powers afforded to a debtor-in-possession under Subchapter V. However, certain features of Subchapter V, which are not presently contemplated by the Legislation, may be also beneficial for Australian SMEs and perhaps the focus of further legislation—particularly, the ability to  reject burdensome contracts and pay administrative expenses over the life of the restructuring plan.

In the UK, the Corporate Insolvency and Governance Act 2020 (UK) (CIGA) came into force in June 2020. CIGA is part of the UK’s response to the pandemic and introduces a number of “debtor friendly” measures to English restructuring and insolvency law. A key aspect of the restructuring measures introduced by the CIGA is the wide-ranging moratorium, pursuant to which directors apply to Court for an initial 20 business day enforcement moratorium, which can be extended for a further 20 business days without creditor consent or indefinitely with creditor consent, while a restructure is negotiated. The moratorium is broad-based and extends to the enforcement of claims by landlords and secured creditors.

In contrast, the new Australian process appears to leave open the prospect of secured creditors enforcing against assets of the company that are critical to the success of a rescue attempt. The apparently limited nature of the moratorium while a plan is being prepared under the new laws, and the inability to bind dissenting secured creditors to a plan submitted to creditors, may restrict the potential for the SME rescue alternative to significantly advance the number of successful debt restructurings for small businesses.

Other key considerations

Eligibility

As previously mentioned, the new measures introduced by the Legislation apply to eligible incorporated SMEs with total “liabilities” of less than AUD $1m. 

The term “liabilities” is defined broadly in the Regulations. When one considers unpaid rent, tax debt, employee entitlements, and bank or other lending, total aggregate liabilities for SMEs are likely to reach, if not exceed, the AUD $1m threshold in a large number of cases. In addition, the final Regulations do not exclude contingent liabilities from the calculation of debts and claims for the purposes of the AUD $1m threshold. This represents a noteworthy change from the draft Regulations, which excluded contingent liabilities from the definition of admissible debt or claim which is used to determine eligibility. 

Will the current threshold represent a ‘barrier to entry’ for a number of insolvent SMEs?

Secured creditors

It is proposed that secured creditors will only be bound to the extent of their unsecured debt. If the entire amount of their debt is secured (that is, the value of their collateral security is equal to or greater than the value of their debt), the secured creditor can only be bound to the extent that it consents to be bound by the plan.

Furthermore, it is proposed that the fact that the restructuring plan has been made will not prevent a secured creditor from realising or otherwise dealing with their security interest unless the Court makes orders to that effect, or the:

• secured creditor accepted the proposal to enter into the plan (i.e. ‘voted’ in favour of the plan)

   

• plan prevents the secured creditor from doing so

This position is therefore similar to that of a secured creditor in relation to a deed of company arrangement in voluntary administration.

In a similar way, it is also proposed that SBRPs will be prohibited from disposing of property of the company that is subject to a security interest unless the disposal is in the ordinary course of the company’s business, with the written consent of the secured party or with leave of the Court.

These factors may represent challenges for an SME to successfully restructure under the new process.

Remuneration

The Rules provide that the SBRP is to only charge a fixed fee for the new process, such fee to be agreed upon by the board prior to the appointment of the SBRP. That said, the Rules also include an exemption from charging only a fixed fee as agreed with the board where costs are incurred by an SBRP associated with defending legal actions brought by other parties, by stipulating that the board must decide on a method for working out the SBPR's remuneration in the event of legal proceedings.

Interestingly, the provision for the SBPR's remuneration is separated into:

• a fixed agreed fee, decided by the board - for the restructuring generally

   

• further remuneration specific to the work performed for the restructuring plan, to be calculated as a percentage of payments made to creditors

Conclusion

It will take some time for the full effect of these reforms to have an impact within the SME space in Australia. 

First, it will be necessary to assess the ‘first wave’ of eligible companies that undertake the new process in order to gauge their success (or otherwise). 

Secondly, as with any new legislative regime, it is anticipated that the Courts will be asked to intervene in order to clarify, or develop, the Legislation in meaningful respects.

Thirdly, the Australian Government has recognised that it will take time for directors, accountants and other professionals to embrace and test these reforms and, to ensure that SMEs do not miss out on utilising these reforms, eligible SMEs will be able to declare their intention to use the new process (which declaration must be lodged with ASIC), after which time the directors of the company will then be afforded certain further temporary relief in connection with the insolvent trading liability (for up to three months) and compliance with ‘statutory demands’ (for up to six months).

In terms of broader reform, it is understood that the Australian Government intends to consider structural corporate and insolvency law reforms as part of its ongoing economic recovery model for Australia in 2021. 

This may be undertaken through a ‘root and branch’ review of our existing law and to this end, commentators have speculated that specific areas of consideration could include:

• an enforcement moratorium to be made available for an insolvent entity prior to the initiation of formal insolvency proceedings
• a cross-class cram down mechanism under a DOCA or under a creditors’ scheme of arrangement
• a dedicated Court-sanctioned process for super-priority debtor-in-possession financing during formal external administration processes
• a legislative process to permit pre-positioned sales (or ‘pre-packs’) for distressed business.

Again, time will tell.