One of the most common forms of frustration from Australia’s insolvency regime, based on our experience, is the perceived lack of results that come from the process. And by results I mean, dividends! As such, we thought we would use this article to examine a recent (and continuing) external administration, providing commentary on the difficulty facing creditors when “the music stops, and all the chairs are gone”, and how the actions that creditors take can assist the process and maximise their chances of a return.
XYZ Pty Ltd (“the Company”), a family owned and operated rock crushing business based on the NSW/QLD border, appointed Voluntary Administrators (“VA”) upon the director identifying that the Company had dug itself into a financial hole (pun intended). The Company’s asset position included:
- on-going contract works;
- debtors (third party and related party);
- plant and equipment (encumbered and unencumbered); and
- the goodwill of having traded in and around the area for 21 years.
Due to a variety of reasons, including management decisions that could be described as poor (with the benefit of hindsight), the Company had significant cash-flow deficiencies that were quickly being exacerbated by the spiralling decline that breaching credit terms with key suppliers can inspire. The intention of the Voluntary Administration was threefold:
- Provide the Company with breathing space to take stock of the situation;
- Eliminate any non-profitable elements within the business;
- Prepare a compromise proposal for creditors to consider with the benefit of the VA’s independent assessment and report.
It was clear from our initial assessment of the financial position that the immediate winding up of this Company was likely to “blow up” the balance sheet. But I will come back to that … for the VA to be successful the Company needed to continue to trade. For the next 72 hours, our team went through the operational requirements of the Company’s business, building an extensive daily cash flow forecast to support the intended outcome of the VA. As always, insolvent companies do not come with a “money tree” and Administrators’ or more specifically their business partners are not in the business of funding trading liabilities from their own pockets. The numbers have to stack up or the strategy does not work.
Thankfully, the Company’s cash flow looked promising. However, as with all business dealings, external stakeholder support would be essential to the trading success of the VA. First stop – employees. The heartbeat of most businesses, our experience tells us that if the employees are not supportive, then the gig is up. In this situation, the team were on-board. Next stop – contract counterparties (customers). The lifeblood of the business, without the revenue generated from the customer contracts, we are unable to feed the cash flow forecast. We had two main parties that the Company was engaged with at the date of appointment. Initial indications from both parties was that they would support the VA trade-on strategy. And finally the suppliers – the food that provides the business with energy. Without supplier support, the jigsaw puzzle could not be completed. The symbiotic nature of the relationship between all the key stakeholder groups, for the Company, means that as VAs we must have all parties in agreement for the process to have a chance of success. Remember, insolvent company; limited moratorium; the VAs are on a tight clock.
Unfortunately, in this scenario, one supplier who was owed a substantial amount of money refused to engage with the VAs, despite the potential to be guaranteed payment for the work done during the VA period, on favourable terms, to alleviate some of the suppliers own cash flow concerns. In our opinion, emotion clouded good judgement in this situation. The supplier had nothing to lose in supporting the VAs’ continued trading, having been guaranteed payment, by statutory right (sec 443A of the Corporations Act), once the VAs had engaged their services. If at the conclusion of the VA, the proposal was unsatisfactory, the supplier could have terminated its dealings with the Company at that point, but at least on an informed basis and with some income from its dealings with the VA.
In this situation, the refusal of this supplier was not the death knell to the VA strategy, being a service replicated by other providers to the Company. However, when this party was approached by one of the contract customers, the resulting conversation “spooked” the customer and shortly thereafter that contract was terminated on the grounds of insolvency. Bye bye trade-on strategy … the Company ceased to trade and the balance sheet went KABOOM! [We do note that the recent legislative reform regarding Ipso Facto clauses may have saved the day here, but that is another story].
Whilst it was too early to determine the likely returns that would have been available to creditors if the VA strategy was successful, our view is that the likely outcome would have been above 50 cents in the dollar. We are now forecasting a return to creditors of below 10 cents in the dollar.
The reason why the return to creditors was adversely impacted so much was that when ceasing to trade a number of dominos toppled at once:
- Employee entitlements were crystallised;
- Plant & Equipment was sold on a fire-sale basis, crystallising encumbrance shortfalls;
- Contract termination resulted in damages claims, compromising the debtors;
- Inventory was sold on a fire-sale basis rather than in the ordinary course; and
- Goodwill evaporated.
We have engaged with the creditor in question, another family business, on numerous occasions during the course of the external administration process. It is our view that the consequence of the decisions made at that point were not considered or likely to have been foreseeable to this creditor. They simply were hurting at the thought of not getting paid and concerned about what it meant for them. However, nearly two years on, a dividend has not been paid to creditors due to the nature of the contractual disputes that have arisen due to the Company ceasing to trade.
In the time pressured and often opaque environment of the early stages of any insolvency process, particularly when there is consideration for continued trading, it is difficult to know what the right decision to make is likely to be. Understanding your rights as a creditor, asking the right questions and taking the time to consider the strategy as a whole will help guide your decision making. And if you need a sounding board to help you work through that decision making process, then remember that Insolvency Intel is only a phone call away.
Partner, Jirsch Sutherland
Ph 1300 265 753