‘Phoenixing’ rising: corporate misuse of FEG sparks crackdown

This week’s TGIF considers the recent proposals to crackdown on rogue directors and reduce the burden on FEG to pay unpaid workers.

A last resort – but for who?

On 17 May 2017, the Federal Government published a consultation paper inviting submissions on options for law reform to address corporate misuse of the Fair Entitlements Guarantee (‘FEG’) scheme.

FEG steps in when a business goes bust and there are insufficient funds to meet employee entitlements. Costs of the scheme, and to the taxpayer, have skyrocketed recently with amounts totalling more than $1 billion being paid out in the past five years alone.

The consultation paper sets out a number of options for reform and was shortly followed by a policy announcement from the Federal Opposition outlining its position to stamp out misuse of FEG and, in particular, illegal “phoenixing”.

This week we look at what has triggered this cost blowout, what options are on the table and provide our view as to what approach might be the most effective.

Is reform really needed?

Government assistance programs to protect employees have been around since early 2000 effectively acting as a ‘safety net’ to protect unpaid workers caught up in corporate insolvencies.

These programs were complemented by reforms to the corporations legislation and the introduction of Part 5.8A which imposed criminal and civil penalties on those who enter into an arrangement or transaction with the intention of reducing the recovery of employee entitlements on insolvency.

However, these provisions are almost never utilised (with a strike rate of zero) and, in the 2015-16 financial year, the total assistance provided by FEG blew out to $284.1 million. This cost, and the fact that FEG rarely recovers more than 10% of monies advanced, has placed these issues firmly on the legislative agenda.

Who is to blame?

The Federal Government cites “sharp corporate practices” for the increasing trend. These practices are said to include:

1. utilising corporate group structures so that employees are employed by a separate entity with limited realisable assets;

2. transferring assets to another company prior to liquidation to avoid liabilities;

3. appointing a friendly liquidator who won’t conduct investigations; and

4. receivers and liquidators keeping proceeds realised from circulating assets.

The rise of phoenixing

Most of the attention has been focused on the practice outlined in point 2 above but, of course, this is not in and of itself an illegal activity. And herein lies part of the problem.

While it is completely permissible for directors of a company that has gone under to continue business through another corporate entity, it is the identification of illegal phoenix activity that makes its detection so difficult.

As it currently stands, the task most often falls to well-resourced liquidators who, through their investigations, are able to uncover and identify transaction patterns of directors as indicia of the activity.

ASIC has some initiatives to combat illegal phoenix activity but this is not enough to prevent an estimated cost to the Australian economy in excess of $3 billion.

Proposals for reform

The Federal Government has put forward a series of measures to address these issues which include:

1. re-drafting section 596AA to reduce the burden of proof for a successful action and specifying the scenarios to which the provision applies;

2. imposing a contribution requirement on solvent group members to meet the unpaid entitlements of their related entity; and

3. lifting the penalties for serial offenders and extending the scope of the disqualification powers of ASIC.

The Federal Opposition has taken this last idea one step further and foreshadowed the introduction of a director identification number (DIN), for all directors, to track unscrupulous directors. A $50 fee would be payable for a DIN.

What’s the answer?

A combination of the reform proposals will likely generate the best outcome for the taxpayer.

We think an objective test under s 596AA is more reasonable than the current position. Such a test, either as an assessment of the transaction entered into or the actions of the directors themselves, will more likely capture a broader range of behaviour.

The contribution requirement, whilst novel, has been adopted in other common law jurisdictions in certain limited circumstances. There is little case law on the operation of contribution orders but the threshold of what is “just and equitable” seems to have developed as the appropriate test. However, given the obvious attack on the corporate veil, we see real difficulties with this suggestion being embraced.

Whilst director tracking may be a step too far, it is imperative that whatever is put in place can stop these activities before they happen as opposed to placing reliance on unfunded liquidators to enforce provisions which deserve a collaborative and “front-foot” approach from the regulators.

Next steps

Submissions are open to the Government’s proposals until 17 June 2017.

How it responds to the view of the public remains to be seen, however, insolvency reform is a “hot topic” at the moment. Whatever is ultimately put forward, it can be safely assumed that, given the upward shift in FEG payouts, any solution will be swiftly implemented