Overview
For distressed small businesses, there are two options for directors in seeking to “save” the company or its business instead of proceeding to an immediate liquidation.
Under Part 5.3A of the Corporations Act 2001 (Cth) (Act), directors can appoint a voluntary administrator. One of the outcomes of voluntary administration is that creditors may vote to approve a deed of company arrangement (DOCA) which sets out the terms relating to the payment of creditors and the company’s future.
Since 1 January 2021, it has also been possible for directors of an eligible small business – with debts not exceeding $1 million – to resort to the small business restructuring (SBR) process in Part 5.3B of the Act. Essentially, directors can appoint a small business restructuring practitioner, who will work with the directors to come up with a restructuring plan (Plan) that may see the company continue to trade out of its difficulties.
A key issue arises in relation to attempts by directors to manipulate the vote – by “stacking” votes in favour of related parties – to secure their desired outcome in a voluntary administration/DOCA or SBR scenario.
So what can creditors do to protect their rights, and ensure they have a seat at the table in the course of an external administration?
When does vote stacking occur?
Vote stacking has been a common occurrence in practice. It has often been used in conjunction with so-called “phoenixing” behaviour designed to defeat the claims of creditors.
In essence, illegal phoenix behaviour occurs when directors of an insolvent company conspire to transfer its assets to a newly incorporated related entity (often with the same directors) for little or no value, leaving the insolvent company as an empty shell that proceeds to liquidation. This is done to avoid outstanding debts, including employee entitlements, supplier claims and tax obligations.
The manipulation of the vote can also occur outside a phoenix scenario, when directors seek to push a DOCA or Plan over the line with the support of friendly creditors after it becomes apparent independent creditors will vote in favour of the directors’ desired outcome.
While there are now provisions in the Act – including the creditor-defeating disposition provisions in sections 588FE(6B) and 588FDB which permit the recovery of transactions designed to prevent, hinder or significantly delay property becoming available to meet the claims of creditors – enforcement depends on proper investigation being conducted by an external administrator.
In the phoenix context, directors may seek to appoint an external administrator who will collude with them to shift assets or refrain from conducting the required investigation into the company’s affairs.
Alternatively, to enhance their control over the outcomes of creditors’ meetings – with a view to defeating a challenge to the administrator appointed by the directors, or other attempts by creditors to hold management to account – phoenix operators may stack the vote by increasing the value of related party creditors’ voting rights and power. This is often done by a related party creditor taking an assignment of a substantial debt, but only paying nominal consideration and still voting for the full value of the debt.
Aside from phoenix activity designed to effectively end the existence of the company, directors could also seek to manipulate the vote to ensure support for a DOCA or Plan which is designed to achieve the continuation of the company under the control of the existing directors (or related parties) and to compromise a significant proportion of existing creditors’ claims.
Challenging vote stacking in a voluntary administration/DOCA scenario
The Insolvency Practice Rules (Corporations) Amendment (Restricting Related Creditor Voting Rights) Rules 2018 (Cth) (Amendment Rules) took effect on 7 December 2018.
The Amendment Rules amended the Insolvency Practice Rules (Corporations) 2016 (Cth) (Rules). They were introduced with the specific intention of targeting the manipulation of votes by directors following ongoing industry concerns and public debate.
The Amendment Rules amended the Rules by:
- inserting new rule 75-95(1A) – which requires an external administrator to ask any creditor voting an assigned debt for evidence of the debt and the consideration for the assignment; and
- inserting new rule 75-110(7) – under which the value of any related party creditor vote for an assigned debt is to be calculated as the value of the consideration given for the assignment.
In effect, these amendments prevent the practice of vote stacking in a related party context in a voluntary administration/DOCA scenario. If a related parry takes an assignment of a pre-existing debt purely to play the “numbers game” and obtain more votes at a creditors’ meeting, it will be held to the actual amount (typically little, if anything) during the vote.
This offers significant protection for creditors. They now have a simple process under the Rules to challenge improper vote stacking practices and ensure they have a genuine say on whether to approve a DOCA that has been put forward, potentially by a friendly administrator working with the directors. This avoids the need to pursue a costly court application seeking to invoke the exercise of the court’s discretion to invalidate a DOCA (or any underlying creditors’ resolution) on fairness grounds.
Challenging vote stacking in a SBR scenario
The Corporations Regulations 2001 (Cth) (Regulations) provide similar creditor protections in the course of a SBR.
During a SBR, “affected creditors” are given right to vote on material issues, including on whether to adopt a Plan. The Regulations contain various provisions in determining the value of an affected creditor’s claim (and therefore the extent of its voting entitlement).
Under regulation 5.3B.25(2)(a)(ii), if a person became a creditor by the purchase or assignment of another creditor’s original debt, then the value of its claim will be limited to the value of the purchase price paid.
It is also an offence under regulation 5.3B.25(3) to give (or agree or offer to give) an affected creditor valuable consideration with the intention of securing the acceptance or non-acceptance of a Plan. This is a very useful additional means for independent creditors to prevent voting manipulation by directors and their related parties in the course of a SBR.
Takeaways
Recent legislative changes give creditors important protections against improper vote stacking practices by directors and their related entities designed to secure the directors’ desired outcome – which may include preventing a proper investigation into their misconduct before a company became insolvent.
These protections provide a convenient and cheaper alternative to creditors than the previous process – under which the only option was to apply to the court to overturn a decision, DOCA or Plan on the basis of general fairness considerations.
Please get in touch with Alyce Corbutt or Matthew Kumnick if you are a creditor or insolvency practitioner and want to explore your options to challenge a vote in the course of a voluntary administration or SBR which may have been the result of manipulation and improper vote stacking by directors and their related parties
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