The difference between legal and illegal phoenix activity

Are businesses legitimately restructuring to deal with the financial fallout of COVID-19 or just avoiding paying their debts? ASIC’s senior executive leader for small business engagement and compliance Diana Steicke explores.

With some companies experiencing financial stress due to conditions created by the COVID-19 pandemic, restructuring a business may be an option available to keep operating. However, some directors — in the hope of saving their business — might engage in an illegal type of restructure commonly known as illegal phoenix activity.

The Australian Taxation Office (ATO) defines “illegal phoenix activity” as when a company is liquidated, wound up or abandoned to avoid paying its debts.

Difficult decisions

Australia has about 2.8 million companies, the majority of which are small businesses. It is a competitive marketplace and, unfortunately, not every business will succeed. This may not be the consequence of mismanagement or misconduct, but because the business could not weather a disruption to the market they operate in or the global pandemic.

As the impact of COVID-19 continues to be felt across the economy, some companies will continue to face financial difficulty. ASIC expects directors will be monitoring their company’s viability and some will face difficult decisions. Directors might decide to restructure their business or close their companies and start again, which doesn’t necessarily mean they have engaged in illegal phoenix activity.

Our insolvency regime and recent reforms provide directors with options to legitimately restructure their business. New Australian government measures — including a debt-restructuring process and a simplified liquidation pathway for incorporated businesses — commenced on 1 January 2021 as part of the Corporations Amendment (Corporate Insolvency Reforms) Act 2020 (Cth). These measures apply to eligible incorporated small businesses with liabilities of less than $1m.

Legitimate rescue vs illegal phoenixing

The key difference between a legitimate business rescue and illegal phoenix activity is the director’s intentions. It becomes a problem if it is done to remove assets or other financial obligations from the reach of creditors when winding up — and when directors benefit from it. If a new company is getting the assets for free or at “mate’s rates”, for instance, that constitutes illegal phoenix activity.

Odd though it sounds, the Corporations Act 2001 (Cth) does not define illegal phoenix activity. Instead, if proved, a director will likely be found to have breached their duties, or possibly engaged in misleading and deceptive conduct or similar fraudulent misconduct. Sometimes, other people are involved who facilitate directors to engage in illegal phoenix activity and may be equally liable as the director.

The Treasury Laws Amendment (Combating Illegal Phoenixing) Act 2020 (Cth) enacted in February 2020 was introduced to hold company directors and officers accountable if they engage in illegal phoenix activity.

Company officers can be penalised for engaging in “creditor-defeating dispositions”, as can those who facilitate companies entering such transactions. ASIC, and the court, in certain circumstances, can also order the return of property or financial gains received as a result of these dispositions.

The law also prevents a director from improperly backdating their resignation or resigning from their role if it leaves a company with no directors. If a director or the company do not notify ASIC of a director’s resignation within 28 days of it occurring, the resignation will be the date the notice is received — inherently preventing directors from backdating their resignation. Directors will need to apply to ASIC or the court to fix an earlier resignation date.

Enforcement action

These reforms supplement the combined resources of ASIC, the ATO and other Phoenix Taskforce members to detect and disrupt illegal phoenix activity and, in turn, protect those impacted by such conduct.

ASIC will continue to distinguish those who engage in illegal phoenix activity from the legitimate failures and restructures, and consequently target those who do the wrong thing. In the first half of 2021 alone, ASIC is targeting 40 investigations of high-risk company directors and of illegal phoenixing.

ASIC has a range of other powers to take action against illegal phoenix activity and more broadly, target those who fail to comply with their directors’ duties. Under section 206F of the Corporations Act, ASIC has the power to disqualify directors from managing corporations for up to five years if the accused has been an officer of two or more companies within a seven-year period and those companies were wound up and a liquidator provides a report to ASIC about the company’s inability to pay its debts.

The ultimate cost

Illegal phoenix activity is something we all pay for. According to a 2018 PwC report commissioned by the ATO, the Fair Work Ombudsman and ASIC, illegal phoenixing activity costs the economy between $2.8b and $5.1b each year based on activity between 2015–16. More than half involved unpaid trade creditors — the most immediate victims — but unpaid taxes accounted for much of the balance.

While most directors are doing the right thing, it’s important to know when to seek professional legal and accounting help to keep businesses away from any risks. But with companies that are at risk, directors need to be hyper-aware.

Untrustworthy advisers will try to take advantage of these circumstances, promising to save businesses and avoid those pesky liabilities for a small fee. If the advice you get doesn’t appear right, or if it sounds too good to be true, get a second opinion from another adviser.

More than ever, we all need to be alert to the bona fides and credibility of those we do business with. Make full use of ASIC’s business registers and be on the lookout for warning signs. Late and unpaid bills, an apparent reluctance to engage, and similar and frequent customer or trade supplier complaints can all be red flags.