What is a phoenix company, what makes them so illegal?

How do you spot one and what should you do about it if you suspect phoenix activity is occurring?

To answer that question we need to delve somewhat into the history of bankruptcy and corporate insolvency.

In the 1700’s if an individual debtor could not pay their creditors they may have found themselves on a boat and transported to our wonderful colony. While laws differed amongst Australian states and territories right up until the 1980’s you may still have been sent to goal for failing to pay your debts. Debtors who attempt to abscond or defraud their creditors can still be imprisoned.

Despite our affinity to our bushranger heritage, no wonder entrepreneurs or the promoters of ventures wished to do business through a corporate entity rather than risk being shipped to the lucky country and/or goaled in the event the venture did not succeed.

The first corporations or “joint-stock companies” were established by Royal Charter in around the 1600’s one of the most widely known in Britain was the East India Company. 100 years after the passing of the Bubble Act of 1720 which forbade the formation of joint-stock companies (due to stock speculation) early corporations emerged from their original royal charters, monopolies and sharing of risk capital was transformed by the Limited liability Act of 1855.

In 2015, for an application fee of $463 you can register a company which limits your liability to the capital invested in the venture. In the great Australian spirit of a “fair go” our modern Corporations Act 2001 (Cwth.) includes an insolvency regime which is designed to not punish company directors for honest mistakes or events that were unforeseeable or outside of their control.

However, there will always be those that abuse the law for their own dishonest financial gain and enter the Phoenix: a long-lived bird that is associated with the sun and regenerates or is reborn in a flash of flame as it rises from its own ashes.

Unlike Phoenix Arizona (which I suspect was named for the association with the sun), phoenix activity could be likened to the Snowy Mountains Scheme town of Adaminaby when in 1957 facing ruin from the creation lake Eucumbene the whole town was picked up and moved 9kms to start again in its current location. The original town was renamed Old Adaminaby and was never to be seen again.

I suspect Phoenix activity has been happening in one form or another since corporations came into being. In 1996, the Australian Securities Commission took the first serious look at the issue and estimated annual losses to the Australian economy caused by phoenix activity to be between $670 million to $1.3 billion. In 2012, a report commissioned by the Fair Work Ombudsman estimated the impact to be approximately $1.8 to $3.2 billion per annum.

Just what exactly is this cost and why is it considered fraudulent or illegal?

Let us look at two simple (“illegal”) phoenix style transactions.

Example 1.  Old Co1 has the following balance sheet and has incurred trading losses during the year of $150,000:

Assets $100,000
Unpaid Super $(50,000)
Shareholder Loan $(100,000)
Trade creditors $(100,000)
Shareholders equity $(150,000)

If Old Co1 was liquidated through proper channels and the Assets sold for $100,000 then the superannuation would be paid and the other creditors receive a dividend of no more than 25 cents in the dollar.

Instead the director decides that in order to protect the company’s assets they will transfer the assets and business name to New Co1 at the written down book value of $100,000 by repaying the shareholder loan.

Old Co1 would then have a balance sheet which, looks like the following:

Assets $0
Unpaid Super $(50,000)
Shareholder Loan $(0)
Trade creditors $(100,000)
Shareholders equity $(150,000)

The superannuation which has priority under the law does not get paid and the creditors receive nothing. Creditors are left to take action against the company or the director seeks out a low cost liquidator to pay to wind the company up.

Why is this transaction illegal?

As a start it goes against the fair go principle and I’d go as far as saying it’s down right Un-Australian. Legally, the transaction may be voidable under section 588FE of the Corporations Act as an unfair preference to the shareholder (and have to be repaid). A liquidator; however, has the task of finding funding to take court action against the shareholder and the transaction has to have happened within a certain time periods before the company was wound up.

The cost of the director’s action is the asset realisations which aren’t used to pay creditors (in this example employees miss out on their $50,000 in superannuation and trade creditors their dividend of $25,000 or a total of $75,000).

Example 2. Old Co2 has the following balance sheet and has also incurred trading losses during the year of $150,000:

Assets $100,000
Depreciation ($90,000)
Unpaid Super $(60,000)
Trade creditors $(100,000)
Shareholders equity $(150,000)

The director decides that New Co2 will buy the assets and business name from the company for their written down book value of $10,000. Old Co2 would then have a balance sheet that looks like the following:

Cash $10,000
Unpaid Super $(60,000)
Trade creditors $(100,000)
Shareholders equity $(150,000)

The director then appoints a liquidator to wind up the company resulting in the employees receiving $10,000 but going unpaid for $50,000 of superannuation. Trade creditors loose $100,000.

Why is this transaction illegal?

Well we don’t know what the assets are really worth. If as in Example 1. they were worth on the open market $100,000 then New Co2 has received a bargain and Old Co2’s creditors have lost out on receiving $90,000.

A liquidator should take court action to attempt to recover the lost $90,000 from New Co2 as the transaction was uncommercial (i.e. the director caused the company to sell its assets too cheaply).

Illegal Phoenix activity costs the economy

The above examples are phoenix activity at its simplest. In reality illegal phoenix activity is far more complex and usually involves numerous companies holding different asset classes and liabilities and often also interposed with trusts.

The extent of the cost to the economy can only be estimated but as this type of misuse of the company system is so unfair there has been a Government Inter-Agency Task force involving nearly all of the various state and federal departments for many years.

In 2012 various amendments to laws were passed to make this type of activity more difficult to pull off included the Corporations Amendment (Phoenixing and Other Measures) Bill 2012 (Phoenixing Bill) providing the Australian Securities and Investments Commission with the power to wind up a company that has been abandoned in certain circumstances; and Tax Laws Amendment (2012 Measures No. 2) Act 2012 which, provides for personal liability to attach to directors for a company’s unreported and unpaid superannuation and PAYG withholding which is more than 90 days overdue.

What to look out for?

Spotting a phoenix can be tricky but common traits can include:

Assets or business names being transferred between companies without formal documentation;
Aggressive accounting depreciation policies vs. tax depreciation rates;
Transfer of employees between entities;
Sequential registration and deregistration of companies operating from the same address;
Non-reporting of superannuation and PAYG withholding liabilities; and/or
Continual changes in corporate trustee companies.

If you suspect a company director of being involved with phoenix activity then you should contact the Australian Securities and Investments Commission to discuss your concerns.