16 minute read
Insolvency Outlook
by AICM
John Winter Chief Executive Officer ARITA – Australian Restructuring Insolvency & Turnaround Association
To say that we continue to live in strange times would best be described as an understatement. For those of us in the restructuring, insolvency and turnaround market, the conditions we see continue to defy the old rule book.
Where did all the insolvencies go?
The number of formal insolvencies in Australia halved after March 2020. While this is a global phenomenon found across most developed economies it has been driven in Australia by:
z Massive stimulus (also global driver)
z Largely “free” money through low interest rates (also global)
z Protections on enforcement especially commercial leases and loans
z ATO withdrawing all enforcement activity
z General “signalling” from the Government e.g. temporary insolvency protections leading directors to believe that their insolvency issues were not problematic.
Despite most of those measures having either been fully or largely wound down, the level of insolvency activity has not recovered. We are still at 40-50% below pre-COVID levels of external administrations. Of course, this doesn’t at all align with the general publics or the media’s view of what is happening in the economy. The perception persists that these must be halcyon days for insolvency practitioners when, of course, the opposite is true.
Indeed, you might have expected to see an increased take up of advisory work to help businesses navigate the turbulent times but that didn’t transpire either. “Safe harbour” and other advisory work has also fallen to low levels based on anecdotal feedback from our members. Though, we do know that a lot of major companies, especially listed ones, did undertake a safe harbour engagement as a risk management strategy for if market conditions worsened sharply. This use of the regime was less about actual genuine concerns about insolvency than it is simply a wise insurance policy for directors and ensured that they had a “Plan B” readily to hand if conditions worsened.
Of course, the lack of formal appointments and the parallel reduction in informal advisory work to financially distressed businesses, implies that directors saw stimulus and protections as a “get out of jail free card” and have simply ignored their director obligations and kept trading.
Interestingly, COVID stimulus may well be hiding a longer-term trend. Research by ARITA revealed that insolvencies per company in Australia have been in long term decline anyway. And the start of that decline aligns with when interest rates started their downward move towards zero. Without question, it shows that the free availability of debt has propped up companies that probably should have ceased operating.
That being said, there are obvious signs starting to emerge for a return to some level of normality. The most obvious is the expectation of interest rate rises. As the price of debt increases, businesses will need to focus on their viability. Helpfully, it should also drive a long-lost quest for productivity.
Throughout the years of the pandemic accountants in public practice continued to report that clients had never been so cashed up courtesy of that aforementioned stimulus. But that is beginning to wind down with stimulus long finished. The acceleration of that has been brought about buy “shadow lockdowns” occurring in most States that have cut into profitability and therefore their reserves. And, of course, most other protections around rent relief and the likes are now off, too.
As a result we will, necessarily, start to see a progressive rise to a more natural – and healthy – level of insolvency.
But most trade creditors remain firmly out of the market for initiating major recovery actions or pursuing formal windups of derelict debtors. We suspect that this is because many no longer see the commerciality in initiating wind-ups on their own – a view likely arising from an expectation that their creditors may likely have very large tax and secured debt that will wipe out possible returns.
The ATO’s disappearing act
Speaking of tax debt, this is perhaps the most important and underappreciated aspect of the pandemic. The ATO is, of course, the initiator of the vast majority of windup actions in normal times. Unlike commercial creditors, the ATO needs to undertake windups regardless of the commerciality of the outcome. Yet the ATO has been almost totally absent from the market since March 2020. This has been taken as a major “signal” to directors of distressed businesses that the ATO was out of play and led to using the ATO as a de facto lender. While there was never an official policy statement to this effect, it is clear that the government allowed the ATO to act as an informal funder to businesses throughout the period. And there’s no doubt that that informal funding has been extensively taken up.
The ATO started making noises about a return to the market early in 2022, though actual activity has remained close to zero until the end of March. Now we believe that some 50,000+ directors have been written to giving them 21 days’ notice to get their reporting affairs in order and highlighting that they be subject to Director Penalty Notices or garnishee orders.
This represents a huge change in signalling.
Of course, we won’t see actual DPNs, garnishees or windups of any significance until after the Federal election on this timeline and that is extremely politically expedient for a government not wishing to have bad news stories of COVID or disaster-effected small businesses being shut down by the ATO in that heightened election news cycle.
Banks disappeared, too
Major lenders have also stayed well away from major recovery action since before Hayne Royal Commission. Banks were, of course, “highly supportive” of borrowers throughout the pandemic and went to even greater lengths to not take enforcement action against delinquent borrowers. This was backed up by regular public statements by major lenders and the Australian Banking Association that borrowers would be assisted by their lenders.
Alongside this, most banks had radically cut their teams who manage distressed borrowers over the last 5 years. Interestingly, there is a significant scale up now happening in those teams. But their approach is now profoundly different, and we expect there is a new normal which will see it remain that banks will be much less inclined to take formal enforcement.
There have been wide reports of banks using a limiting of providing extra credit as a way to move poor quality/higher risk profile borrowers on. Of course, this is a completely reasonable approach given the attacks on banks around the Hayne Royal Commission about not taking greater steps to ensure responsible lending.
But in this instance, it leads to those borrowers needing to depart to second or third tier lenders instead. The banks also either compromising debt or offering generous extensions to other borrowers.
But it is important for credit professionals to note that other creditors will not be able to rely on major banks leading recovery actions against distressed companies in the future as banks will remain primarily concerned about reputational risk in their decisions.
Deregistrations – the new phoenix?
There’s another important issue coming to the fore through COVID and it comes from a very obvious observation: we can see lots of businesses have closed their doors but they haven’t appeared in the insolvency statistics. So, what happened to them? Well, it appears that they are ghosting out of existence and avoiding the proper solvent or insolvent shutdown processes.
In a normal/pre-COVID year there are approximately 10,000 corporate insolvencies per year. We now know that there are more than 40,000 companies deregistered by ASIC in addition to those formal insolvencies. That means that only 1 in 5 shutdowns goes through the “proper” process.
Recently, ASIC has started to take some action against directors for false statements (i.e. that there were actually debts owing) around those deregistrations and that’s shed some light on this occurrence.
So, could deregistrations be the new phoenix? Well, to an extent, yes. We do have plenty of anecdotal information that dodgy advisers are
using the ghosting out technique as their primary exit strategy. They coach financially distressed directors to pay enough for key creditors to go away and then ignore the rest of their debt. They do this alongside ceasing all ATO and ASIC reporting for the entity. Then they leave it to be deregistered.
Away from this very dodgy usage, there is a counter argument that it’s not necessarily a bad “public good” outcome if all creditors are properly satisfied (if not fully paid), but avoids any checks and balance and all investigations. The foundation principle of pari passu may go by the wayside and ATO debt is particularly at risk if not reported on prior to abandonment.
Regardless, this issue may that become a very big public policy problem as we exit COVID, start to see rising insolvencies and the return of the dodgy advisers.
Where do we see the strain?
You will no doubt see articles in this Risk Report from other contributors who will be sharing their data on areas of risk, but from the viewpoint of insolvency professionals, we are seeing five factors that are really driving insolvency right now:
1. Supply chain crunches/delays – companies being placed under strain because essential supplies delay their ability to complete their own product or service to generate revenue.
2. Supply chain cost increases/accelerating inflation – these impacts are reducing profitability of companies especially in areas where there are fixed cost contracts or limited ability to pass on those costs.
3. Lack of staff to meet demand – again causing companies to be placed under strain because they cannot deliver their own product or service to generate revenue.
4. COVID-economy shifts – some segments such as international tourism, CBD hospitality, international education and the likes will take a long time to return, if they ever do. Businesses in these areas are unlikely to make it through.
5. Weather/disaster events – the sequence of bushfires, floods, storms and so on having taken a serious toll in some regions.
In terms of sectors that we see under insolvency strain, these include:
— Supply chain costs and crunches are hitting construction and related sectors the hardest.
We are likely to see biggest rise in insolvencies there – signs already coming through with
Probuild and Condev. A ripple effect is also likely.
— Supply chain also a big problem for transport – where rising fuel costs will be major factor.
— COVID-economy shifts continue to impact hospitality and tourism (e.g. tourism now domestic versus international) and staff issues are also most prevalent there.
Impacts of the pandemic on the profession
We are now over two years into the level of insolvencies being 50% below baseline. Insolvency firms are, of course, businesses themselves. So unsurprisingly, that reduction in work has had a profound and negative effect on the profession.
It comes on top of long-term reductions in staffing as work has been in decline for 8 years – a product initially of our long pre-COVID economic growth.
When insolvency numbers collapsed in March 2020, revenue in most firms dried up as well. More than half of all insolvency practices ended up on JobKeeper. But most firms have had to significantly reduce their headcount leaving many firms now skeleton staffed. This may well be a challenge when work returns as firms will not readily have the capacity. This is compounded by it being very hard to attract good junior-mid level staff with salaries for these staff being much, much higher outside insolvency (yes, despite all views to the contrary, insolvency actually doesn’t pay very well!)
Registered liquidator numbers remain resilient, though, and there’s becoming quite a generational change occurring. This gives us the base from which to rebuild. Firms are working to get ready for the projected increase in work – but it’s hard to plan for alongside the scarcity of mid-level talent.
So, this may lead to a squeeze of availability but ARITA is working with ASIC and AFSA to plan around this.
Has COVID changed insolvency forever?
There’s a genuine question around whether both debtor and creditor behaviour has been altered. We think that its likely that the actions of all – especially ATO and lenders – may have trained in new behaviours.
Debtors learned that they could “push back” and may now have an expectation that they do not have to fully meet their debts. Alongside this, the
current government is moving towards “debtor in possession” and an expectation that creditors will simply compromise debts/wear the pain of losses.
And, as previously mentioned, many trade creditors may no longer have the desire to formally pursue debts over viability concerns. Additionally, that exploitation of deregistrations and “informal exits” may become part of the new normal.
All of these observations combine to suggest that we won’t be going back to the old patterns and that creditors will firmly be expecting much more debt forgiveness in the futures
Small business restructuring: Fizzer or slow burn?
While we are on the subject of “debtor in possession” we should consider the government’s signature legislation in the area – small business restructuring.
The idea for SBRs came from ARITA in 2014. It was a concept targeted only at micro businesses where there was little risk of exploitation. The concept was given the approval of the Productivity Commission in their 2014 Business Setup, Transfer and Closure Inquiry Report. And it remained “on the books” as something the government was meant to respond to from that time.
As COVID hit the government searched for quick fixes for what was perceived as a coming tsunami of insolvencies, and they landed on this concept. Sadly, it was largely on the name that they took from our framework and that with which the PC agreed.
Instead, the government opted for a cut and paste” of Part 5.3A into Part 5.3B – with other oddities added – making it a complex and therefore expensive approach. They also broadened its access up to firms with a $1 million in debts.
The government claims that SBRs is one of the most major reforms undertaken in 30 years but all points to it being practically limited in application. At this time, well over a year since commencement, still only 40 Small Business Restructures have been engaged with only 30 making it to a plan. Much will depend on the outcome of the election that will be known by the time you read this.
The Morrison Government was making noises that they may open up the requirements (e.g. increase debt levels to $5 million). We see this as a problematic response that will lead to abuse. It’s the form and complexity of the current legislation that is the problem and there’s no appetite to address this.
Lots of insolvency firms are now marketing SBRs as a tool, but the take-up remains low, even in recent weeks as we’ve started to see inquiry levels pickup around ATO’s renewed activity. So, while use of the SBR regime may pick up, it’s our view that this is a missed opportunity that is unlikely to be a major tool to save distressed businesses in its current form.
The law reform landscape
What’s coming down the pipeline in terms of change? Of course, everything is totally dependent on the outcome of the May Federal election.
There are no guarantees that the Morrison government will pursue any pre-election reform proposals even if re-elected noting that there is no significant draft legislation (just announcements). On top of that’s, there’s absolutely no expectation that an incoming Labor Government would have the same agenda.
What does remain on the agenda of the Morrison Government are proposals around the following:
— One year bankruptcy – an idea which we are vehemently opposed to for the risk that it causes. Far better to consider enhanced early discharge options
— Push to have more people, including directors, go down the path of Debt Agreements rather than bankruptcy – also a proposal we oppose.
Debt Agreements were designed mainly for consumer personal insolvencies. Pushing complex personal insolvencies into them will only lead to more legislation and therefore more cost. Everyone loses from that. In addition, they juts aren’t fit for that purpose.
— Free ASIC searches – this is unquestionably good for all, especially creditors. IF there is a change of government credit professionals should join us in pushing an incoming government to deliver on this Budget announcement.
— Unfair preferences – this Federal Budget announcement on a prohibition on amounts less than $30k and more than three months prior isn’t backed up by any draft legislation.
While we know that credit professionals love the sound of this, it’s the end of pari passu and it will also leave many small business insolvencies unable to find a liquidator. Liquidators often have to rely on preference recoveries to fund them to do their statutory work.
— $5,000 “grant” for unfunded liquidations – also a Federal Budget announcement alongside the unfair preference statement. Given the complexity of work that liquidators must do under the Corporations Act, this doesn’t even begin to cover their costs, especially once ASIC fees are paid. Both above will make it unlikely for liquidators to take unfunded small jobs especially court liquidations meaning that you won’t be able to rely on the historic processes.
— Clarifying treatment of trusts – the government has budgeted for work to continue on this.
It’s a task left unfinished since Harmer Report of the 1980s and needs to be addressed to bring down cost of insolvencies (most SME insolvency have a trust structure).
— Response to the excellent Safe Harbour Review
Panel report – government has funded some implementations (unspecified) but stopped short of adopting the Panel (and ARITA’s) recommendation of a “root and branch” review of insolvency laws to simplify and reduce cost.
If there is a change of government, there is little indication from the ALP as to any interest they have in this space. ARITA will continue to push for a “root and branch” review of our insolvency regime to be conducted by the Australian Law Reform Commission – a repeat of the 1980’s Harmer Inquiry which was the last fulsome review we had. This is a 3-5 year project but it’s essential if we want to radically reduce the cost, complexity and accessibility of our restructuring, insolvency and turnaround regime and be fit for the future.
John Winter
