The Regulator

Creating new companies from the ashes of failed concerns is illegal if the aim is to avoid paying employees or debtors, or escape other financial obligations.

Illegal phoenix activity

Creating new companies from the ashes of failed concerns is illegal if the aim is to avoid paying employees or debtors, or escape other financial obligations, writes John Price.

Company failures can be nothing more than bad luck. But there are some directors who deliberately walk away from a failed company with the intention of avoiding liabilities and subsequently establish a new company to conduct the same business – this is known as “phoenix activity”. Directors and their business advisers can face tough sanctions, including imprisonment, if they are involved in such activities.

This illegal activity is costly to individuals, businesses and the Australian economy. A PwC report commissioned by the Fair Work Ombudsman entitled Phoenix Activity: Sizing the Problem and Matching Solutions, estimated that the total annual detrimental cost of illegal phoenix activity on the Australian economy is approximately $3.19 billion. Of that amount, the report estimates annual costs of:

• Up to $655 million for employees, in unpaid wages and other entitlements.
• Up to $1.93 billion for businesses, as a result of unpaid debts for goods and services that have been provided.
• Up to $610 million for government, mainly as a result of unpaid tax – but also due to payments made to employees under the Fair Entitlement Guarantee.

From the Australian Securities and Investment Commission’s (ASIC) perspective, the key characteristics of illegal phoenix activity involve circumstances where:

• A company fails to pay its debts.
• Directors of that company act in a manner which intentionally denies unsecured creditors (usually small businesses and employees) equal access to that company’s assets in order to meet unpaid debts.
• Within some period of time soon after the failure of the initial company (usually within 12 months), a new company commences using some or all of the assets of the former business, and is controlled by parties related to either the management or directors of the previous entity.

The unfair competitive advantage that operators get by engaging in illegal phoenix activity has a significant impact across a variety of sectors, including small business.

ASIC’s latest enforcement report, Report 476 ASIC enforcement outcomes: July to December 2015, released in March 2016, outlines the type of enforcement actions that ASIC takes in relation to misconduct associated with this type of behaviour.

The report provides details on a range of things including the work that ASIC undertakes when small businesses become victims of misconduct, or where business owners operate outside of the law.

ASIC also runs targeted surveillance campaigns designed to detect and combat illegal phoenix activity. These focus on company directors who have a history of involvement in failed companies, are currently operating in certain higher risk industry sectors, like construction, and who fit other criteria developed by ASIC.

Directors and their business advisers can face tough sanctions, if they are involved in such activities.

While there may not be a single statutory offence for “illegal phoenix activity”, the key characteristics of this type of activity often involve breaches of director’s duties. These include circumstances where directors have not acted in good faith in the best interests of the company and for a proper purpose, asset stripping, making false statements and failing to provide records to liquidators.

During the period July 2015 to December 2015, ASIC took 194 criminal actions against directors and banned 14 directors from managing corporations for the type of misconduct that is often associated with illegal phoenix activity. ASIC also takes a proactive approach to supporting small businesses and helping them to protect themselves from unscrupulous operators.

This includes providing free education to small businesses regarding their obligations under the Corporations Act 2001. Examples include a dedicated small business hub where members of the public can find information about various business structures.

ASIC has also launched the ASIC Guide for Small Business Directors, which provides small business directors with key information relevant to their business type. User-friendly tools, like ASIC’s Business Checks, enable business owners to undertake important due diligence in relation to potential customers, or suppliers, with whom they may be entering into new relationships.