Why The Term ‘Legal Phoenix’ Is An Oxymoron

By Benjamin Caddaye, Law Clerk and Alicia Hill, Principal, MST Lawyers

The Federal Court of Australia’s decision in ACN 093 117 323 Pty Ltd (In Liq) v Interlara Engineering Consultants Pty Ltd (In Liq) [2019] FCA 1489, is of great interest to restructuring and insolvency practitioners. Interlara Pty Ltd had attempted to restructure its business to move priority creditors to a new entity, so ensuring that upon winding up creditors with personal guarantees against Interlara’s directors were paid out. In holding the scheme to be an uncommercial transaction, an insolvent transaction, an unreasonable director related transaction and a voidable transaction, the decision of Derrington J highlights how the Court will treat the phoenixing of a company aimed at defeating the rights of priority creditors.

Background

Interlara Pty Ltd (Interlara) had conducted an engineer consultancy business since around 2001. During its operations, Interlara had several lending and banking facilities with NAB which were personally guaranteed by Interlara’s directors, Mr Lethlean and Mr Burnell. In 2014, Interlara started to experience financial difficulties, and engaged Facilities Care Pty Ltd (Facilities Care) to provide consultancy services.

Facilities Care provided advice to Interlara regarding a potential restructure in light of the fact its existing creditors included secured creditors. Facilities Care advised Interlara that it should do what was described as a ‘legal phoenix’. This involved the establishment of a new company into which Interlara would transfer its business assets, as well as some of its employee entitlements. After the restructure had taken place, Interlara could then be wound up and its remaining assets used to discharge its remaining major creditors, which consisted of the NAB and the Commissioner of Taxation. Interlara obtained further advice from a second restructuring company AMRC Commercial Pty Ltd, which recommended that it adopt the Facilities Care proposal.

The effect of the restructure was to favour the directors over the priority creditors. As employee entitlements crystallise as priority entitlements, they would have been paid out before the NAB and Commissioner of Taxation debts. This would leave any shortfall unable to be paid by Interlara to be recovered personally against the directors through the guarantees, or in the case of the Commissioner, through a Director Penalty Notice. By moving the priority creditors to a new company, upon winding up, the assets of Interlara could be used to discharge the debts which were secured against the directors personally, as the employee entitlements would no longer be present to take priority.

On 7 December 2015, an Assets Sale Agreement was executed, and the restructure was completed, with the assets of Interlara transferred to the newly created Interlara Engineering Pty Ltd (Interlara Engineering). Interlara then immediately resolved to be wound up. On that date, Interlara had creditors of $1.4 million, with $335,000 owed to employees as priority creditors (being the remaining entitlements not transferred to Interlara Engineering) and $600,000 owed to the NAB which was personally guaranteed by the directors. Interlara had assets of approximately $1.1 million and received a further $199,000 under the Fair Entitlements Guarantee Act 2012 (Cth), which is a scheme to ensure employee entitlements are met upon the liquidation of their employer.

After the restructure, Interlara Engineering operated for a period of 44 days before it resolved to be wound up on 22 January 2016, with the Court noting it had probably been insolvent since its inception. Upon winding up, Interlara Engineering owed $775,318.31 in accrued employee entitlements, with insufficient assets to cover those entitlements. It too received an amount of $686,777.31 from the Commonwealth under the Fair Entitlements Guarantee Scheme.

A special-purpose liquidator was appointed to Interlara and sued Interlara Engineering, alleging that the Assets Sale Agreement was an uncommercial transaction, an insolvent transaction, an unreasonable director-related transaction and special-purpose transaction pursuant to the Corporations Act 2001 (Cth) (Act).

Findings

As Interlara Engineering had entered into a voluntary winding up, s 500(2) of the Act operated to stay all proceedings and prevent the initiation of further proceedings against the Company unless leave of the Court was obtained. Derrington J, in this instance, found that there could be little doubt that leave was warranted, as the Agreement was a transaction implemented by Interlara and Interlara Engineering which appeared to have been designed for the purpose of benefitting Interlara’s directors at the expense of its creditors.

The first substantive issue was whether the transaction was an uncommercial transaction pursuant to s 588FB of the Act, with the question being whether a reasonable person in the company’s circumstance would have entered into the transaction. His Honour found that the transaction was plainly not one a reasonable person would have into. He noted that the factors which led to this conclusion were that there was no consideration provided, assets which would have been available to meet employee entitlements were made available to meet the demands of NAB, and there was no real benefit to the company in entering into the transaction whereas there was a substantial benefit to the directors.

The second substantive issue was whether the transaction was an insolvent transaction pursuant to s 588FC of the Act. Derrington J commented that the directors caused Interlara to be wound up in insolvency on the very same day the transaction was entered into.

The third substantive issue was whether the transaction was an unreasonable director-related transaction pursuant to s 588FDA of the Act. In this case the question to be answered was would a reasonable person in the company’s circumstance would have entered into the transaction, having regard to the benefits obtained to the company, the detriment to the company, the benefits to other parties and any other relevant matters. His Honour held that a reasonable person would not have entered into the transaction, as there was no benefit to the company, and although the Assets Sale Agreement did not confer benefits on the directors directly, it conferred on them the benefit of being released from their obligations under their guarantees to NAB.

Finally, Derrington J found that it was a voidable transaction on three different bases.

  • Firstly, having found that the transaction was both an insolvent transaction and an uncommercial transaction it was a voidable transaction pursuant to s 588FE(3) of the Act.
  • Secondly, it was also a voidable transaction under s 588FE(6A), which flows as a consequence of it being an unreasonable director-related transaction.
  • Thirdly, although not pleaded by the liquidator, Derrington J noted that it was a voidable transaction under s 588FE(4) as a result of it being an insolvent transaction.

Derrington J, therefore, made a declaration that the Assets Sale Agreement was an uncommercial transaction, an insolvent transaction, an unreasonable director-related transaction and a voidable transaction and transferred the employee entitlements back to Interlara from Interlara Engineering.

Commercial Considerations

What is clear from the Interlara decision is that, despite the advice Interlara received from Facilities Care, there is no such thing as a “legal phoenix”. Any scheme entered into by a company facing solvency issues which is aimed at defeating the rights of creditors in favour of directors is likely to be met with unfavourable treatment by a Court. As such, this case serves as a warning to any company attempting to conduct phoenixing activity as contrasted with appropriate legal restructuring advice.

If you have any questions about this article of the issues raised by it, please feel free to contact Alicia Hill by email  or call on (03) 8540 0200.