Putting out the fire – cracking down on illegal phoenix activity

‘We didn't start the fire
It was always burning since the world's been turning
We didn't start the fire
No, we didn't light it, but we tried to fight it’¹

The Illegal Phoenix 
Illegal phoenixing is a major problem in corporate Australia.  In this post we consider what illegal phoenix activity is, how the problem is affecting the Australian economy and the recent regulatory crackdown on the issue.

In Greek mythology a phoenix is a mythical bird which obtains new life by rising from the ashes of its predecessor.  Illegal phoenix activity involves the intentional transfer of assets at an undervalue from an indebted company to a new ‘phoenix’ company.  The old company remains with its debts and is often placed into liquidation (or is left to be wound up on the application of a creditor) – stripped of any valuable assets, with nothing left to pay creditors.

How significant is the problem?
Illegal phoenixing has been estimated to cost the Australian economy more than $3 billion a year². Employees, businesses and the Government are affected by:

• unpaid wages and other entitlements
• unpaid debts and unpaid tax
• goods and services paid for, but not provided, and
• the cost to Government of payments made to employees under the Fair Entitlement Guarantee³.  

The negative economic impact of illegal phoenix activity is exacerbated by unquantifiable factors, including the unfair competitive advantage obtained by companies that avoid paying their debts.

Illegal phoenixing in the construction industry in particular lead to a Senate Inquiry, the outcomes of which were published on 3 December 2015 in the Senate Report ‘Insolvency in the Australian Construction Industry’.

Pre-insolvency advisors
The relatively recent advent of pre-insolvency advisors has undoubtedly fuelled an increase in illegal phoenix activity in Australia.

Whilst sometimes touted as a ‘guardian’ against insolvency, many are unqualified and trawl the Australian Securities and Investment Commission’s (ASIC) winding up application notices, preying on directors desperate to find a way out of the company’s financial difficulties.  Debtors all too often find themselves in situations where they incur further debts, in the form of substantial pre-insolvency advisor fees, to ‘rebuild’ their company.  In some circumstances this leads to a commercial resolution with creditors that avoids a formal insolvency, however, in many cases, the advice results in illegal phoenix activity.

Putting out the ashes: how is illegal phoenixing regulated?
There is no legislative definition of illegal phoenix activity, or a specific phoenixing offence.  This has presented difficulties for regulators trying to target illegal phoenix activity, such as the Australian Taxation Office (ATO) and ASIC⁴.   Those regulators have therefore developed indicia to spot illegal phoenixing.  Central to these is an ‘intent’ by directors and company secretaries to avoid liabilities.

ASIC, the ATO, the Australian Competition and Consumer Commission and the Fair Work Ombudsman have combined forces to proactively identify, monitor and challenge suspected illegal activity, via the creation of the ‘Phoenix Taskforce’.  Driven by ASIC, the Taskforce uses data matching tools to monitor behaviour, particularly where a failed entity’s directors resurface in the same pursuit under the veil of a new entity.

The Phoenix Taskforce (Taskforce) works closely with the Serious Financial Crime Taskforce which is headed by the Australian Federal Police and monitors and targets criminal behaviour, following the success of Project Wickenby.

So far the Taskforce has been focused on identifying and (hopefully in time) removing from the industry those involved in enabling illegal phoenix activity; being pre-insolvency advisors, the lawyers who work on the pre-insolvency transactions and the liquidators who willingly take the appointment as liquidators of the company shell and who fail to take any proper steps to investigate or prosecute the directors.

Much of the Taskforce’s work remains confidential; however, the Taskforce conducted two recent joint raids by the ATO and ASIC on over 13 homes in Melbourne and the Gold Coast in August of this year.  The raids were conducted after investigations identified the homes as being linked to firms providing pre-insolvency advice who would encourage debt-ravaged businesses to participate in illegal phoenix activity as well as assisting businesses to avoid paying taxes on an estimated collective sum of $22 million in unreported income.

In comments following the raids, the Deputy Commission of Taxation reiterated the dangers of unqualified pre-insolvency advice and confirmed that the Taskforce was keeping a close eye on service providers in this section of the market.

Further, in a pro-active approach, ASIC have commenced a program which sees them writing to directors of companies subject to winding up applications with a view to reminding those directors of the serious consequences associated with phoenixing.

The James Nelson decision – a judicial shift?
Despite it being prevalent, the regulators have had limited success in prosecuting illegal phoenix activity.

In ASIC v Somerville & Ors (2009) 77 NSWLR 110, the New South Wales Supreme Court found eight directors of unrelated companies to have acted in breach of the Corporations Act 2001 (Cth) by engaging in what ASIC regards as illegal ‘phoenix’ activity and that their legal adviser, Mr Timothy Donald Somerville, also contravened the Corporations Act by being involved in the directors’ breaches.

The court found that Mr Somerville had devised a series of transactions, with the appearance of legitimacy, to bring about asset stripping and disadvantage to creditors.  On 24 September 2009, the New South Wales Supreme Court disqualified Mr Somerville from managing corporations for six years commencing on 24 October 2009. The Court also disqualified the directors from managing corporations for a period of two years commencing on 24 October 2009.

In 2013 and 2015, following investigations by ASIC, the two pre-insolvency advisers from the Gold Coast, Graeme Dwyer and Paul Scott, were found guilty of creating and using a fictitious director in companies in order to avoid any real director potentially being liable for breaches of directors’ duties because of transactions entered into - see ASIC's media release.

However, the punishment handed down by the court (six months imprisonment, suspended upon entering in a $1,000 recognisance to be of good behaviour for a period of 12 months and eight months imprisonment, to be served by way of an intensive correction order, respectively) is unlikely to be sufficient to be a serious deterrent to others who operate on the fringes of the law and who may wish to engage in similar behaviour.

More encouragingly, in the recent Federal Circuit Court decision of Fair Work Ombudsman v James Nelson Pty Ltd & Anor [2016] FCCA 531 (James Nelson), the Federal Circuit Court of Australia ordered Ms Langridge, a sole company director and secretary, to pay around $98,000 in penalties for her involvement in facilitating illegal phoenix activity.  Ms Langridge failed to pay the employees of her company their appropriate wage entitlements, in contravention of the Fair Work Act 2009 (Cth) and transferred her company’s assets to a new phoenix company.

Legislative Reform
In March 2016, the Fair Work Amendment (Protecting Australian Workers) Bill 2016 (Cth) was introduced into the Australian Senate (FWA Bill).  If enacted, the FWA Bill would have enabled courts to require directors of phoenix companies to pay amounts owed by failed companies and orders disqualifying certain persons from managing corporations.  It would have also given the Fair Work Ombudsman increased powers to pursue employers and directors engaging in phoenixing in their personal capacities.  Following the dissolution of parliament earlier this year, the FWA Bill lapsed and it remains to be seen whether the FWA Bill will be re-introduced in the next parliamentary session.

Separately, the Australian Government’s proposed changes to insolvency laws to introduce a safe harbour for directors whilst attempting to restructure a business, may reduce the rates of illegal phoenix activity by providing better ways for troubled companies to turnaround.

Conclusion
The difficulty defining and proving illegal phoenix activity has made it hard for regulatory authorities and courts to prevent and penalise it.  The Government’s investment into specialised taskforces and the Senate Inquiry reveal its prioritisation and commitment to the issue.  The recent James Nelson decision may indicate that the Government’s initiatives are paying off.  It will certainly be interesting to monitor the effectiveness of the Government’s initiatives over the next few years.

_____________________

[1] Chorus from ‘We Didn’t Start the Fire’ by Billy Joel, from the Storm Front Album, released 1989.
[2] Phoenix activity: sizing the problem and matching solutions, commissioned by Fair Work Australia (read the report at: http://bit.ly/2e1NNqo). 
[3] Ibid.    
[4] http://www.aph.gov.au/Parliamentary_Business/Committees/Senate/Economics/Insolvency_construction/Report/c05#content - ASIC, Submission 11, p. 26.

Scott Butler

Partner

+61 7 3233 8653

sbutler@mccullough.com.au

Ann Watson
Lawyer
+61 7 3233 8638
awatson@mccullough.com.au