Businesses in New Zealand are facing challenging times. Directors of companies are pulled in all directions - employees to care for, bills to pay and creditors chasing them for payments. Directors are not alone in feeling the extreme levels of stress, fear and anxiety.

Directors however should not now be prolonging the inevitable where they had no viable business pre Covid-19 and if post Covid-19 there is no reasonable prospect of the company recovering from the current circumstances. If circumstances are dire, the shareholders should be looking to appoint a liquidator to avoid debt increasing and further harming creditors.  Liquidation does not necessarily mean the end of trading altogether.  Often the business is sold and sometimes there is an opportunity to be involved in the successor company. 

Trading On - Viable Businesses Versus Insolvent Companies at 31 December 2019

Viable companies at December 2019 that fail as a consequence of Covid-19 have relief measures available to them. The government has eased the rules around trading in insolvent circumstances to increase the survival prospects for businesses that were profitable at the start of COVID-19. This is to encourage directors of businesses that were viable pre Covid to not place their company into liquidation prematurely with the fear they be may held personally liable under 135 and 136 of the Companies Act.

The same relief is not afforded to businesses that have traded recklessly leading into lockdown and then carried on causing further demise to their creditors. Directors of companies that were trading insolvently pre Covid-19 could be held to have breached directors duties or found to have breached Section 380 of the Companies Act 1993 “Carrying on business fraudulently or dishonestly incurring debt”. Directors should be aware of their obligations and be taking proactive steps. The government’s message to show kindness also includes caring about the impact on creditors.

If the sudden and rapid economic effects of the COVID-19 pandemic, to be followed by the anticipated global recession and an expected long period of recovery, mean it is now unrealistic to continue trading, then liquidation is an option for both solvent and insolvent companies.

Liquidation – The Process

An insolvent liquidation is where there is a shortfall to creditors. A solvent liquidation is advanced to enable capital profits to be distributed tax free.

Some company failures are for reasons out of the control of the director. Many liquidations that are likely to commence in June/July 2020 will be attributable to the impacts of Covid-19.

Liquidation is not always the best answer and can be the last resort after exhausting all other options. Company compromises or the new Debt hibernation scheme are certainly options to review first as well as the loan schemes available. To some, liquidation is inevitable, there is insufficient light at the end of the tunnel, lack of funding or too much uncertainty or personal risk. Liquidation can be an opportunity to restructure, review, revise and build again and reduce personal liability.

Liquidators on appointment take control of the business and the process going forward. The liquidator acts for the creditors. They recover available assets, investigate the company’s affairs and distribute any available funds to creditors in the order of priority specified by the Companies Act 1993.

Liquidation can mean new beginnings

Liquidating a failed company does not necessarily mean the end of trading a business again or the inability to be involved in the liquidation process. Each liquidation is different.

Many directors have started again, learned from their failures and gone on to run highly profitable businesses. Many have relied on the exceptions in the Phoenix company rules to buy back the business and trade with the same/similar name.

With the agreement of the liquidator, there can be an opportunity to buy the business assets and Intellectual property (including brand/tradename) and trade again with the same/similar company/ trade name. An “exception” under the Companies Act is the ability to purchase from the liquidator and to then issue a successor company notice within a specific time period.

Directors of failed companies who do not comply with the exceptions at Section 386D are prohibited from being, directly or indirectly, a director, manager or promoter in a phoenix company or business.

Those that comply with the exceptions can go on to trade again with the support of their suppliers and customers.

Hive Down – restructure with immediate liquidation and buy back

An independent liquidator can consider a sale back to the director or management team or related party. The purchasing entity is termed a "phoenix" company, if the same (or a similar) company or trade name is used and the previous director or management team remain in a management position.

Since Insolvency practitioners hold and manage company assets in a fiduciary capacity and make decisions that can materially affect the total amount available for distribution to creditors, they typically gain independent valuations to support a sale back and prefer to test the market. In some cases the only market is the persons who were involved in the failed company.

The business assets of a struggling company in liquidation are sold usually following a robust sale process and at market valuation and after considering the specific circumstances leading to liquidation. The proceeds of realisation flow back to the company in liquidation to be distributed to creditors. The purchaser of the assets (related party or third party) needs to acquire the assets following a fair process and to fairly pay for those assets. A hive down restructure requires careful planning to protect the brand, company reputation, and supplier/customer relationships. Restructuring where creditors in the failed company are not paid fully has its challenges for the new company to gain continued supply and support.

A hive down structure needs to consider:

• Restraints of trade
• Transferability of contracts
• Staff retention
• Customer / supplier support
• License renewal
• Retention of tax losses

The new “phoenix” company has an obligation to issue a successor company notice within 20 working days of the purchase - when this occurs, it gives the director of the new company (successor company) protection from personal liability. It also informs suppliers they are dealing with a new entity and need new trade terms. A similar system can also apply to a management buyout, where the purchaser wishes to buy assets rather than shares.

Where Phoenixing Goes Wrong For Directors And Managers 

A phoenix company can also arise for the wrong reasons, or can go very wrong, typically where a director of a failed company transfers assets to a new company at undervalue or alternatively transfers the assets for value but fails to take the required steps defined at Section 386A of the Companies Act 1993.

A sale of assets pre liquidation by the directors to another company prior to the liquidation of the failed company at undervalue, or even no value will be investigated by the liquidator. This is commonly referred to as ‘phoenixing’ and is contrary to insolvency law because fair value should be obtained from the sale of assets. The expectation is that the liquidator will seek to recover assets that were disposed of at undervalue or no value and add them to the pool of assets available for distribution to creditors.

Liquidators will also investigate the affairs of the company and decisions taken by the directors in the lead up to the liquidation. Directors can be held responsible to compensate the company for matters such as breaches of directors’ duties, insolvent trading or unreasonable director related transactions.

For those directors that sell at a market value and continue in a governance or a management role or as named directors in a new company structure before liquidating the failed company, they need to be aware of the phoenix company provisions in the Companies Act 1993 and apply to the court as a matter of urgency for Court approval to use the same/similar company/trade name.

Voidable Dispositions

Section 53 of the Insolvency Practitioners Regulation Amendments Act introduces sections 296A to 296D of the Companies Act in relation voidable dispositions of company property during the specified period. The specified period begins on the date on which an application is made to appoint a liquidator under 241(2)(c) and ending at the time the liquidator is appointed.

Disposition is not voidable if made in the ordinary course of business , or by an administrator of receiver or under a Court order.

The amendments will void the transfer of a company’s assets once a liquidation application has been filed, other than in the ordinary course of business, where the court has given leave, or where the liquidator has ratified the transfer, save for transfers by an administrator or receiver;

Concerns on Phoenixing and Remedies

Creditors of a business that failed leaving them exposed will often see it as wrong that the business can be transferred to a new corporate vehicle, leaving the creditors of the failed company with no recourse to the business for payment of the old debts. This is a valid concern but only when proper value has not been paid or where the director has sought to defraud creditors.

There are many existing remedies in the Companies Act and other legislation to address the harms caused by the misuse of the voluntary liquidation process. Examples of existing provisions that help the creditors of the old company are enforcement of directors duties and fraud and dishonesty offences, repayment orders, the setting aside of prejudicial and voidable transactions and banning people from being directors.

While the phoenix provisions in the Companies Act are sometimes criticised for being too narrow, they do provide important protections for the creditors of the new company. Creditors of the new company should not be led into believing (wrongly) that the business has been longer established than it has been. The provisions themselves do not focus on the creditors of the old company.

When Sale pre liquidation can go wrong – Phoenix Company Director Liability - Example

In Commissioner of Inland Revenue v Clooney Restaurant Ltd [2020] NZHC 451 the High Court granted relief to the Inland Revenue against a phoenix company and its sole director for the disposition of property intending to prejudice creditors; the breach of director duties; and the breach of s 386A of the Companies Act 1993 (phoenix company director liability).

Upon receiving winding up proceedings from Inland Revenue seeking to recover tax liabilities, the company director transferred the Clooney restaurant business to a new company Clooney Restaurant Ltd before the proceedings to place the failed company into liquidation.

The High Court found that the transfer was prejudicial as there was no right to recourse against the transferred property. The court also found that the director breached his duties to the vendor companies and said “Relieving the companies of their only significant asset, while leaving them without means to meet substantial liabilities, is not in their best interests”: at [17].

The High Court also found that the unmet tax liabilities were exclusively caused by the directors actions and that as a director of the new company and a director of the phoenix company, the director had breached s 386A(1)(a) of the Companies Act rendering him personally liable for the phoenix company’s debts.

Under s 348 of the Property Law Act 2007, the phoenix company was ordered to pay compensation to the vendor companies in the sum of $383,959.40. The director was ordered to pay the CIR $383,959.40 under s 301 of the Companies Act.

The decision can be found here.

Conclusion

A struggling company can consider liquidation and starting up again but the right processes need to be taken to protect the creditors, the director and the liquidator.

Creditors of companies that fail are often shocked and angered by the ability of directors of the failed company to start up a new business and carry on as though nothing happened.

They cannot accept that they are suffering because of the losses they are facing whilst the people they see as being responsible for the losses appear to suffer no ill effects.

Who is at fault?

It is important to note that the debt owed to the creditor is owed by the company, not the directors personally.  A limited liability company has its own separate legal identity and it is generally only when the directors have given personal guarantees in favour of particular creditors that they become personally liable for the debts concerned.

Furthermore, company failures are not always attributable to actions of the directors.  Failures come about for a variety of reasons including economic downturn, natural disasters, default in payments from customers and major clients changing supplier.

Starting over

There is no automatic bar to a director of a failed company starting up a new business on the failure of the old one.

There are provisions within the Companies Act 1993 in respect to starting and operating phoenix companies within five years of the commencement of the liquidation of the failed company.

Section 386B(1) of the Companies Act 1993 defines a phoenix company as follows:

A phoenix company means, in relation to a failed company, a company that, at any time before, or within five years after, the commencement of the liquidation of the failed company, is known by a name that is also -

1. a pre-liquidation name of the failed company; or
2. a similar name

A pre-liquidation name means any name (including any trading name) of a failed company in the 12 months before the commencement of that company's liquidation.

A similar name means a name that is so similar to a pre-liquidation name of a failed company as to suggest an association with that company.

There are some exceptions to the rules regarding phoenix companies, for instance Court approval can be obtained (Section 386A(1)) or a Successor Company Notice can be issued (Section 386D).

You can see more detail regarding phoenix companies in the article on our website written by Peri Finnigan, Phoenix companies:  what exactly are the rules here?

What can be done to stop them?

Directors don't always just walk away unscathed by the failure of their company.

There is a personal toll in the stress that they have been under leading up to the failure, the personal loss they may have suffered through funds they had put into the company or through personal guarantees provided to financiers or suppliers, and the sense of failure that most feel when their company is liquidated.

Their actions will also be subject to scrutiny by the liquidator of their company.

Liquidators will investigate, among other things, the activities of the directors to establish if the directors have breached their duties.  This can lead to legal proceedings being taken against the directors if they are considered to have acted in breach of those duties and caused loss to creditors by doing so.

If found to have been in breach of their duties or reckless in their actions the Court can impose monetary penalties on the directors to the level it thinks is appropriate to the circumstances.

One of the statutory duties imposed on liquidators is to report to the Registrar of Companies where they suspect the company or any director of the company has committed an offence that is material to the liquidation against the Companies Act 1993, the Crimes Act 1961, the Financial Markets Conduct Act 2013, the Takeovers Act 1993 and the Insurance (Prudential Supervision) Act 2010.

The liquidators will also report to the Registrar of Companies on any director who they believe should be banned from being director because of the belief that their actions were wholly or partly responsible for the failure of the company or because they have had two or more failed companies in the previous five years.

Breaches of the banning orders and operating a phoenix company can, on conviction, lead to penalties of up to five years' imprisonment or a $200,000 fine.

In conclusion, whilst it may seem unfair that the directors of a failed company can just carry on with business as usual after the failure, there are provisions available to have them brought to task and penalised where appropriate.