New restructuring process for Australian small businesses when temporary COVID-19 relief measures are lifted on 1 January 2021

Treasurer Josh Frydenberg announced on 24 September 2020 (view announcement here) the introduction from 1 January 2021 of an innovative new restructuring process for Australian small incorporated businesses with liabilities less than AUD1 million, which adopts key aspects of the US Chapter 11 bankruptcy process.

Fact Sheet issued 24 September 2020 outlines the reform

The Government has published on Treasury’s website a fact sheet (view the fact sheet here) setting out the details of the reform ahead of the release of legislation (Fact Sheet).

The Fact Sheet suggests that the new restructuring procedure is scheduled to commence on 1 January 2021, when the Government plans to unwind the temporary relief measures to prevent businesses entering administration due to business interruption caused by COVID-19.

It would now appear there is clarity around when the COVID-19 temporary relief measures may be unwound, being 1 January 2021.

Temporary COVID-19 relief measures that are scheduled to end on 1 January 2021

The temporary measures introduced to assist businesses to navigate the COVID-19 business interruptions have included:

• the relief for directors from personal liability for trading while insolvent; and
• the increase in the threshold at which creditors can issue statutory demands on debtors from AUD2,000 to AUD20,000, and the time debtors have to comply with statutory demands from 21 days to six months.

These temporary measures were initially introduced in March 2020, and then extended recently until 31 December 2020.

These measures have avoided many businesses entering external administration, though have resulted in a build-up of businesses that are over-indebted and need to restructure their liabilities to survive. The new restructuring process is designed to assist small businesses in these circumstances.

New restructuring process for small business includes elements from US Chapter 11

The new restructuring process utilises elements of the US Chapter 11 process. In particular, the process leaves directors with management control while they work up a restructuring plan with the assistance of a “small business restructuring practitioner” (Practitioner).

One month to prepare a restructuring plan under moratorium protection

The process would see directors select and appoint a Practitioner, following which together they would have one month (20 business days) to prepare a restructuring plan to present to creditors for approval (Plan).

Crucially, during this initial planning period the directors would maintain their management control of the business, and not be replaced in their management function by insolvency practitioners as occurs in voluntary administration, liquidation and many receiverships.

This feature is termed “debtor in possession”, which essentially means that existing management stays in place, and is borrowed from US Chapter 11. This is a fundamental shift in the restructuring of insolvent businesses in Australia, albeit it is only proposed to apply to small businesses.

Time will tell whether this debtor-in-possession procedure may be rolled out more widely once it is implemented for small business.

During this initial one month planning period a moratorium on creditor enforcement action would apply to give the business breathing space from adverse creditor action.

In addition, Ipso facto protections that otherwise apply to prevent termination or exercise of rights under contracts by counterparties upon a company proposing a scheme or entering voluntary administration, would also apply to this new restructuring process for small business.

The Practitioner’s role, certifications to creditors, and fees

The Practitioner’s role is to assess the financial position of the business, identify creditors, and assist the directors to develop a credible restructuring plan to present to creditors for approval.

The Practitioner would certify to creditors that they consider the business has shared its financial affairs with creditors to enable them to make an informed decision when they vote on the Plan, as well as certifying to creditors that the business is likely to be able to commit to and deliver the Plan.

The Practitioner would not assume management control of the business, nor personal liability for new debts or liabilities the business incurs as it continues to trade, as is the case for receivership or voluntary administration. In this sense the Practitioner’s role is greatly reduced.

The directors can continue to trade (despite the company being insolvent) in the ordinary course of business during the one month period while the restructuring Plan is being devised. The Practitioner must approve any trading outside the ordinary course, and in this sense performs a monitoring role.

If the restructuring Plan is approved by creditors, the Practitioner would assist in making distributions to creditors under the Plan.

The Practitioner’s role of assisting to develop the restructuring Plan would be performed for a fixed fee. If the Plan is approved by creditors, the Practitioner would propose a fee arrangement for overseeing implementation of the approved Plan, based as a percentage of funds disbursed under the Plan. In this way, the Practitioner’s fee arrangements are designed to give the business and creditors certainty, and achieve cost proportionality relative to the asset pool being administered.

Secured creditors appear largely unaffected

The Fact Sheet is clear that existing rights of secured creditors, and the existing statutory rules for payment of priority creditors such as employees, would remain unaffected.

This would mean that secured creditors could exercise rights against their secured property without limitation by the Plan, and that secured debts could not be compromised under a restructuring Plan.

Voting on the restructuring Plan – 50% of creditors voting in one class

A restructuring Plan would be approved if 50% of creditors approve it, voting in one class.

The restructuring Plan, once approved, binds unsecured creditors only.

Related party creditors would not be entitled to vote on the restructuring Plan.

Secured creditors would be treated as holding secured debt only to the extent of the realisable value of their collateral (secured property), beyond which they would be treated as unsecured creditors and vote under and be bound by the Plan.

Given this, and the fact that only unsecured creditors are bound by a restructuring Plan, it would appear to follow that only unsecured creditors would vote as one general class upon a restructuring Plan. This detail remains to be clarified.

Employees get paid out

The Fact Sheet states that employee entitlements must be paid out before a restructuring Plan can be put to a creditor vote.

This suggests that a business must have at least some level of working funds to propose a restructuring Plan, and cannot simply shift liabilities onto employees by accruing employee entitlements without paying them.

This also suggests that, given employees and secured creditors likely stand outside of a restructuring Plan, the key focus of the Plan appears to be unsecured creditors such as trade creditors and suppliers that do not take purchase money security interests, the ATO, landlords, and unsecured lenders.

New streamlined liquidation process for small business

The proposed reforms also encompass a new simplified liquidation process that would be available to small business if the restructuring Plan is not approved by creditors, in addition to the conventional voluntary administration procedure.

The conventional liquidation process would be streamlined in the following ways, namely by:

• reducing the extent of voidable transactions such as preferences that a liquidator can bring;
• reducing the liquidator’s reporting requirements;
• removing creditors’ meetings and committees of inspection; and
• simplifying the process of proving of claims and paying/receiving distributions.

All the above simplifications are likely to be welcome developments in small-scale and largely unfunded liquidations.

Mechanisms to prevent misconduct and abuse of process

Small businesses often have various debts owing from directors or relatives, and a very strong sense of ownership by their founders. These factors among others can breed activity that is unfavourable to creditors in times of distress.

To protect the interests of creditors, the existing illegal phoenixing provisions of the Corporations Act that were introduced in February 2020 would apply to the business assets and the restructuring Plan. Further, in connection with proposing the Plan to creditors, the directors would be required to make a declaration that they have not engaged in illegal phoenixing activity, presumably in the period leading up to the restructuring Plan being presented to creditors.

In addition, related party creditors could not participate in the voting upon a restructuring Plan.

Creditors would have the power to convert any simplified liquidation process that follows a rejected restructuring Plan, into a conventional liquidation, thereby enlivening the liquidator’s full suite of powers to investigate and avoid antecedent transactions.

Finally, the restructuring Plan process could only be used by any given company/directors, one time within a prescribed period, which is proposed in the Fact Sheet as once every seven years.

Transition into the new regime

It is proposed in the Fact Sheet that businesses that wish to access the new regime now, can declare their intention to do so now, and thereby enter a transition phase until the process becomes formally available on 1 January 2021.

The Fact Sheet does not provide detail on this transition mechanism, which remains to be clarified in legislation or future announcements.

A new classification of insolvency practitioner for small business restructuring

The Fact Sheet states that a new classification of registered liquidator is to be created, specifically for this small business restructuring procedure.

This recognises that more registered liquidators than currently exist, may be needed to cope with the volume of small business restructuring under this new process.

It may also be the case that the level of experience required to perform the Practitioner role in small business restructuring, differs to larger scale external administration, and so qualification requirements can differ.

The details of this new classification of insolvency practitioner remain to be clarified in legislation or by further announcement.

Moving away from “one size fits all” insolvency, to a tailored approach for small business

The policy behind the new restructuring process for small business is to encourage business owners to actively engage with the process by providing a quick, cheap and easy procedure to restructure their unsecured debts, which is tailored to the scale of the business.

The Fact Sheet recognises that existing voluntary administration and liquidation procedures are complex, lengthy and expensive, and as such probably deter small business from engaging with them and utilising them.

It also recognises that cost and complexity reduces distributions to creditors, especially for smaller businesses, which is an undesirable outcome.

Consistent with this policy, the new small business restructuring process is tailored specifically to the needs of small business.

Concluding thoughts

The proposed small business restructuring process is aimed squarely at the needs small business.

The proposed liability cap of AUD1 million, together with the process requiring that employees be fully paid out before any restructuring Plan, and being limited to compromising unsecured debt only, appear to limit the application of the process to very small-scale businesses.

The key focus of the restructuring Plan under the new process appears to be to compromise debts owing to unsecured creditors such as trade creditors and suppliers who do not hold purchase money security interests, the ATO, landlords, and unsecured lenders.

One cannot help but think that, in order to meaningfully restructure, a small business would have to conduct several sets of restructuring discussions, being with secured creditors, employees, and then unsecured creditors under a restructuring Plan.

This new process does not offer a “one stop shop” for small businesses to restructure, given most small businesses will have at least some secured bank debt or have granted at least some security to suppliers by way of purchase money security interests. Accordingly, it appears that small businesses would still be faced with various sets of restructuring discussions in order to meaningfully and successfully restructure their liabilities.