Chapter 3Purpose and performance of the corporate insolvency system
3.1This chapter examines considers the broad objectives of the corporate insolvency regime, whether those objectives are appropriately set and articulated in policy and legislation, and the extent to which they are currently being achieved.
3.2This chapter highlights several broad categories of concern raised by inquiry participants about the current corporate insolvency system. These include the complexity of the system, poor returns to creditors, poor engagement by debtors, funding gaps and a problematic division between corporate and personal insolvency law.
3.3This chapter summarises approaches taken in other jurisdictions to insolvency reform in recent years, highlighting examples which inquiry participants considered Australian policymakers might usefully examine.
3.4In assessing this evidence, this chapter also examines calls made by inquiry participants for a comprehensive review of Australia’s insolvency law—what many have referred to as a ‘root and branch review’.
3.5The next chapter in this report considers what the appropriate structure, scope and process of a comprehensive review might look like.
The purposes of the corporate insolvency system
3.6As the Australian Restructuring Insolvency & Turnaround Association (ARITA) points out, except in relation to voluntary administration there is no ‘objects clause’ within the Corporations Act setting out the objectives of the corporate insolvency regime. While no legislative definition of the purposes of the corporate insolvency regime exists, the Harmer Report and the Productivity Commission’s 2015 report both provide useful insights as to how those purposes are generally understood.
3.7The Harmer Report summarised the principles and purposes of insolvency law as follows:
The fundamental purpose of an insolvency law is to provide a fair and orderly process for dealing with the financial affairs of insolvent individuals and companies.
Insolvency law should provide mechanisms that enable both debtor and creditor to participate with the least possible delay and expense.
An insolvency administration should be impartial, efficient and expeditious.
The law should provide a convenient means of collecting or recovering property that should properly be applied toward payment of the debts and liabilities of an insolvent person.
The principle of equal sharing between creditors should be retained and in some areas reinforced.
The end result of an insolvency administration, particularly as it affects individuals, should, with very limited exceptions, give effective relief or release from the financial liabilities and obligations of the insolvent.
Insolvency law should, as far as convenient and practical, support the commercial and economic processes of the community.
As far as is possible and practical, insolvency laws should not conflict with the general law.
An insolvency law should enable ancillary assistance in the administration of an insolvency originating in a foreign country.
3.8In its 2015 report, the Productivity Commission’s characterisation of the objectives of the insolvency regime reflected a similar balance of creditor and debtor interests, while placing greater emphasis on the restructuring of economically viable companies. In addition to highlighting the role of the regime in encouraging economic activity through the productive use of assets (discussed below), the Productivity Commission concluded:
The objective of the insolvency regime should be to provide a genuine opportunity for restructure for economically viable companies, without providing incentive for strategic behaviour by debtors and creditors. If restructure is not possible, the insolvency system should aim to provide an efficient (expedient and inexpensive), effective and orderly process for winding up the company. This process should involve consideration of creditors, as well as other stakeholders, and provide certainty regarding future developments. The regime should foster a coordinated approach to recovery of a company, or its assets.
3.9Mr Murray and Professor Harris pointed the committee towards their textbook, Keay’s Insolvency, where they explained that the aims of corporate insolvency law include to:
protect the debtor company from the consequences of its insolvency and release the debtor from its liabilities.
align with and accommodate existing rights in other areas of law.
protect those creditors who take valid security over the debtor’s assets.
ensure equal sharing between unsecured creditors.
investigate the insolvency to the extent of providing some accountability.
efficiently and effectively recycle the insolvent’s assets to better economic use.
assist in the restructuring of an insolvent business and otherwise rehabilitate the debtor.
support the rule of law.
3.10In Keay’s Insolvency, Mr Murray and Professor Harris observed that the ‘aims and purposes [of insolvency law] are generally sound and long-standing, although they are not static, and some wax and wane’. They noted that over time:
…corporate insolvency has assumed a more rehabilitative focus, recognising the need and the ability to preserve value and to promote enterprise, with some element of censure for business failure. Economic purposes of insolvency have also developed in seeing insolvencies as an inevitable product of a competitive economy, thereby necessitating an efficient process of disposal. The rights of creditors have received more emphasis over time, perhaps too much so for the results achieved, while at the same time the protection of security interests continues to be maintained.
3.11The rehabilitative aspect of insolvency law is expressly acknowledged in Part5.3A of the Corporations Act, which establishes the voluntary administration regime. Section 435A of Part 5.3A states that the primary objective of the voluntary administration regime is to provide for the business, property, and affairs of an insolvent company to be administered in a way that:
(a)maximises the chances of the company, or as much as possible of its business, continuing in existence; or
(b)if it is not possible for the company or its business to continue in existence—results in a better return for the company’s creditors and members than would result from an immediate winding up of the company.
3.12As considered in chapter 7, other parts of the corporate insolvency regime provide for the restructuring of an insolvent business and workouts. Reforms in recent years have also been aimed at rescuing financially distressed businesses so that they can avoid formal insolvency and continue to operate.
3.13For its part, ARITA submitted that as part of a broader re-drafting of insolvency law, a clear statement of objectives should be added. ARITA stated that a unified personal and corporate insolvency law should have as its objectives:
- to provide a genuine opportunity for restructure of economically viable businesses, without providing incentives for inappropriate behaviour by debtors and creditors;
- where restructuring is not possible, to expeditiously and efficiently realise the value of the assets of the insolvent business at lowest reasonable cost;
- to ensure directors and other relevant persons have acted in accordance with their duties and where reasonable to do so identify any fraud or other malfeasance associated with the business;
- where individuals become insolvent and have committed no offences, to discharge them from bankruptcy as soon as practicable;
- to ensure that where there is a public interest in the affairs of the distressed business extending beyond the enforcement of the law and the interests of the creditors (for example, the maintenance of critical supply chains or aviation services), that this is made clear to all stakeholders, and is properly had regard to by the relevant insolvency practitioner; and
- to support the development and best practice regulation of the insolvency profession.
- Responding to ARITA’s recommendation on the objectives on insolvency law, Ashurst raised a concern in relation to point ‘e’. It suggested that while there may be instances where a larger public interest required the continuation of a particular business, how this was achieved should be addressed by the government on a case-by-case basis:
The ARITA proposal, if adopted, would result in the introduction into insolvency law of a degree of "moral hazard" to the extent that it may encourage those responsible for the management of some businesses to proceed on the premise that they are too important to fail. Beyond that, such a stipulation may operate as a statutory limitation on the options available to government as to how those goods or services should be supplied in the future.
3.15Ashurst also noted that ‘it is important for any insolvency law to recognise that it is just as important for individuals (in particular, consumer debtors) to be able to restructure their financial affairs as it is for a corporation irrespective of its size’. It advised that if the government were to determine that it was appropriate to adopt a unified insolvency law in Australia, then the principal objective of insolvency law might be stated as follows or similar:
The object of this Act is to provide for the financial affairs of individuals and companies who are insolvent or near insolvent to be administered in a way that:
(a)maximises the chances of those affairs being rehabilitated or restructured; and
(b)only if that is not possible, results in a better return to the creditors of the individual or the company than would result from their immediate bankruptcy.
3.16Ashurst also argued that the law should better acknowledge the importance of the rehabilitation or restructuring of the affairs of companies and individuals in financial difficulty (which should be the ‘primary objective’ of insolvency law).
3.17Like ARITA, the Association of Independent Insolvency Practitioners (AIIP) observed that the ‘purpose or object of Australia’s insolvency laws is substantially absent in the legislation for corporations and individuals’. The AIIP suggested the Harmer Report’s summary of the purposes of insolvency law remained relevant, while observing the need for:
…the addition of narrative to indicate that the objective of the insolvency regime should be to provide a genuine opportunity for restructure for economically viable businesses, and if restructure is not possible, the insolvency system should aim to provide an expedient and inexpensive, effective and orderly process for the winding up [of] the company.
There should not be room or incentives for inappropriate behaviour by directors and officers, debtors and or creditors. Directors must be able to readily understand their obligations with respect to insolvency and their options when businesses experience difficulties.
Creditors must be able to easily understand their rights in relation to recovering the monies owed to them.
3.18Throwing into sharp relief the tension between the purposes of business rescue and the protection of creditor interests (including employees, as priority creditors) the ACTU took aim at what it called the recent ‘counter-productive public narrative encouraging entrepreneurship by destigmatising failure’. In this narrative, the ACTU argued, risk was ‘externalised onto workers, creditors and the wider community’. In contrast to inquiry participants arguing the case for more explicit emphasis on the rehabilitative objects of insolvency law, the ACTU stressed that it stood:
…opposed to any measures that make the existing regime more permissive by further derisking failure and allowing directors and shareholders to externalise losses onto others without consequence. In this regard the previous government’s Covid measures (temporary insolvency measures and increasing the statutory demand threshold) worked against earlier measures designed to increase personal/director accountability (personal property security, corporate accountability (by addressing FEG misuse and combating phoenixing) and liquidator accountability (Insolvency Law Reform Act).
3.19Evidence put to the committee also underlined the function of insolvency in encouraging and facilitating the provision of credit and productive allocation of capital and other assets in the economy. Referring back to the historical public purposes of insolvency law, Treasury explained that the original rationale, which still held, was:
…that what you're trying to do is hold people to account such that you can have security for creditors. That security for creditors then generates the desire to lend money into an economy, you get the inflow of capital and, as a consequence, you can generate economic growth. So economic growth is one of the objectives.
3.20Professor Brand, Society of Corporate Law Academics (SCoLA), emphasised the importance of a well-functioning corporate insolvency system in underpinning the construct of the limited liability company (LLC). The LLC was predicated on the notion that the owners ‘can walk away and not be personally responsible for the debts of the company’, but this only operated to the extent that creditors had confidence in the insolvency system. Setting out the potential economic impact of insolvency law reform, she advised:
…insolvency has tentacles through all of our economy and, more broadly, through society, and that reform of insolvency law has almost a disproportionate capacity to affect broader outcomes—almost more perhaps than many other areas of commercial law. It's uncontentious that well functioning markets require efficient and effective insolvency systems, and the confidence to provide credit is based very centrally on the operation of an effective insolvency system. That's a model that's served us and Western democracies well for a very long time. It enables the assumption that the privilege of limited liability won't lead to destructive or undesirable outcomes.
3.21ARITA noted the importance of insolvency in ‘increasing average levels of productivity in the economy by facilitating structural change within and between businesses and sectors, allowing entrepreneurs and others to learn and experiment, and transferring skills and information between businesses’. ARITA further submitted that in circumstances where a business cannot be saved, ‘it is critical that the insolvency framework enables efficient (in terms of both time and cost) redeployment of employees and capital’.
3.22Reflecting on the evidence provided in other submissions, Mr Michael Brennan, Productivity Commission, told the committee:
… the submissions that I've read seem to reflect a sophisticated view about what it is that we want from an insolvency system: namely, balancing the desire for restructuring to occur and the desire for businesses to be given every chance while, at the same time, not being so naive as to think that it's the goal of the regime to minimise insolvency. Insolvency and business exit play a very important part in maintaining the dynamism of the economy. They ensure that it's an innovative and constantly changing economy. Whilst there's an element of pain associated with financial distress, sometimes business exit is an important way for us [to] get economic growth through innovation and different business models, and in some industries in particular that is a mechanism by which innovation and productivity growth occur.
3.23An OECD paper comparing the insolvency regimes across countries summarised how a well-designed insolvency system contributes to the efficient and productive allocation of capital in the economy:
Policies affecting the way failing firms can exit markets or be restructured can shape aggregate productivity through a variety of channels…These include the strength of market selection – which increases in the economy’s ability to dispose of non-viable firms and facilitate the restructuring of viable firms – and the scope and speed at which scarce resources consumed by failing firms can be reallocated to more productive uses. But market imperfections often generate obstacles to the orderly exit of failing firms, implying that well-designed insolvency regimes are crucial to realise the potential productivity gains from firm exit.
3.24In another OECD paper, ‘Insolvency Regimes and Productivity Growth: A Framework for Analysis’, it was pointed out that a ‘well-functioning exit margin, which sorts successful market activities from unsuccessful ones, is vital to aggregate productivity growth’.
3.25Moreover, ‘[t]he gains to aggregate productivity are magnified if the scarce resources once consumed by exiting firms – capital, labour, skills and ideas – can be reallocated to more productive uses’.
3.26The paper suggests that market imperfections (such as incomplete contracts and bargaining frictions) underpin part of the policy rationale for insolvency regimes. It also points to factors relevant to the optimal design of such regimes, including appropriate regulatory responses to market imperfections. The market imperfections identified include: asymmetric and incomplete information, the potential for the interests of individual creditors to conflict with collective creditor interests, and high transaction costs.
3.27The Australian Institute of Company Directors (AICD) referred to the economic importance of insolvency law in making the case for a comprehensive review of the insolvency regime. The AICD noted its long-standing view that insolvency law reform was:
…a key, and often underappreciated, area of microeconomic reform. In our view, the insolvency regime should encourage entrepreneurialism, maintain employment and enable directors to save businesses that are fundamentally viable in the long-term.
3.28Asked about the value of more clearly and succinctly setting out the high-level objectives of the insolvency regime, Treasury acknowledged:
Good policy flows from having clearly articulated objectives. As you mention, the goals around maximising value, or, if you like, protecting creditors, are very important goals as well to articulate. It serves as a useful guidepost for future reform if you were to pursue reform, but it also serves to explain how the system is meant to function so that people who are operating in the system understand what the goals are. Some people can enter the system with perhaps a different perspective around what the goals could be and then find that their expectations aren't met.
3.29Mr Murray and Professor Harris also suggested there would be merit in having the principles underpinning insolvency law ‘settled and legislated in some way, and measured where possible on an ongoing basis as to whether they are and continue to be met’.
Committee view
3.30The committee considers there would be value in more clearly articulating, in legislation and policy, the guiding principles and objectives of the corporate insolvency system. This will help facilitate ongoing assessment of how the system is performing and enhance transparency and understanding of it.
3.31The purposes of insolvency law were expressed in the Harmer Report, and later in the Productivity Commission’s 2015 review, which placed greater emphasis on opportunities for restructure of economically viable businesses. The committee considers these expressions of the system’s purposes remain broadly sound. At the same time, the committee does not think it would be useful to itself attempt a definitive statement of those purposes. Insolvency law balances a range of complex and sometimes competing interests, and this task requires further consideration and consultation. As will be discussed in chapter 4, the committee considers this work should be done as a dedicated and early aspect of a separate comprehensive review of insolvency law.
Assessments of the system and calls for a comprehensive review
3.32A wide range of inquiry participants argued that the corporate insolvency system was falling short of achieving its purposes. This part of the chapter summarises central and recurring themes in the critiques made of the system as it stands. In doing so, this chapter also outlines the evidence in support of a comprehensive, holistic (or ‘root and branch’) review of insolvency law.
Legislative complexity and the case for holistic reform
3.33A common theme in much of the evidence received was that the corporate insolvency legislative framework has become overly complex, adding cost and hindering access to insolvency processes. As discussed below, a range of witnesses argued that a holistic, comprehensive review of the insolvency law was required to remedy this complexity.
3.34The Business Law Section of the Law Council of Australia (BLS LCA) characterised the insolvency system’s legislative scheme as a ‘piecemeal mishmash of legislative drafting techniques and policy, which have resulted in provisions scattered across various Acts, schedules, regulations, and regulatory instruments’. It recommended that the legislative scheme be ‘redesigned to eliminate unnecessary and obsolete provisions, establish a single source of relevant law, and provide a more easily navigable system for stakeholders’.
3.35Professor Harris also indicated that the ALRC’s current approach in its ongoing inquiry into the legislative framework for corporations and financial services regulation may be useful in resolving some of the legislative and regulatory complexity in relation to insolvency. While the ALRC’s current review is focused on Chapter 7 of the Corporations Act:
…what they are recommending, particularly in terms of legislative drafting and legislative schemes going forward in corporate law, I think, would offer a lot of value to insolvency. Because at the moment we certainly don't have that kind of hierarchical approach that they're recommending in terms of broad-based principles; thinking where the rules fit in; having an independent advisory committee that is basically looking for out-of-date provisions, anomalies, redundant provisions. So that would be very beneficial in insolvency because a number of our rules date back to the 16th century.
3.36Mr Hathway, AIIP, explained that legislative complexity and confusion made it harder for insolvency practitioners to carry out their work, which adds expense and stress for all involved:
In the frustration of our work, this idea of just bolting on answers and not having clarity in our work drives us to courts, and having the confusion of trying to determine on each case brings enormous bearing on the costs of liquidations, if not the emotional costs of running these things. […] Where there's confusion in the legislation there's confusion in our advice, and it leaves the consumers, Australian citizens, very confused when it's sometimes a very traumatic part of their life.
3.37BlueRock submitted that Australia’s ‘unduly complex’ corporate insolvency regime was ‘difficult to understand even for experts in the field’, leading to ‘wasted legal costs associated with the often Herculean task of gleaning an answer to a straightforward question’ on insolvency law.
3.38Dr Duffy, SCoLA, also emphasised the importance of the system being comprehensible, accessible and transparent for the businesses, members of the public, employees and other creditors who might need to engage in insolvency processes.
3.39Mr Winter, ARITA, spoke to ARITA’s ‘very strong belief’ that a comprehensive review was required to address the cost and complexity that had come to characterise the system:
The law has become pancaked by decades of legislation, legislative change upon legislative change, and it's now gotten to the point where—and I'll say this quite frankly; as a non-insolvency practitioner, I've been in this job for nine years, and I know the ins and outs of this—I could not run an insolvency myself. If somebody with my level of expertise is faced with that challenge, what hope does a director of a business have in navigating their way through what is a minefield?
3.40Describing Australia’s insolvency regime as ‘notoriously complex’, the Housing Industry Association also wrote in support of a ‘holistic in-depth review of Australia’s insolvency laws’.
The ‘piecemeal’ approach to insolvency reform in recent years
3.41A range of witnesses characterised insolvency law reform in the years since the Harmer Report reforms as 'piecemeal', arguing this had added complexity and inconsistencies to the system. For example, Professor Harris said insolvency reform over the past 30-plus years had focused on:
…particular issues that are raised— how do particular rules work and can we make them work better? We say, and many others are saying, that this is just adding to the complexity of our system and that really what we need to do is not say, 'Can we make insolvent trading work better or can we make preferences work better?' but, as you just said, Chair, very eloquently, 'How is the system working? What are the goals? What are we trying to achieve? Are we achieving the goals in the best way that we can?' We really haven't had that discussion since the early 1980s when the Harmer committee was convened. We say that the economy has fundamentally changed in that time and that, therefore, this calls for a reconsideration of those fundamental goals, because without that shared understanding of what is the system trying to achieve and is it actually achieving it—it's only once we understand that that we can then investigate the reform of particular rules…
3.42Mr Pearce, BLS LCA, also noted that reforms in insolvency law had been pursued in response to a particular problem, rather than with a whole-of-system perspective. Mr Pearce indicated that a comprehensive review might provide an opportunity for a more holistic approach:
Over the course of a period of time there have been lots of piecemeal bolt-ons to the Corporations Act and to the regulatory regime more generally. A lot of those changes have been focused on particular stakeholder groups and addressing particular issues at the expense of a view of the regime as a whole. Consequently, at times we have an overly complicated system that is expensive to operate that doesn't necessarily focus on what's best as a whole—credit returns, for example. To address those matters, one needs to take a step back to look at the whole system and to do so with all the necessary policy considerations and data. What needs to be done in order to conduct that process? If that's a root-and-branch review of the system, then perhaps that's what needs to happen.
3.43Professor Brand agreed that reforms in recent years had sought to resolve the concerns of specific constituencies, leading to imbalances in a system characterised by varied and often competing interests. She noted that in corporate insolvency law:
…there's a really strong level of competition between lots of different ideas, all of which are right in themselves, but maintaining an appropriate equilibrium requires a fair bit of attention to be paid. I guess we would say that, as a society, insufficient attention has been paid to the helicopter view of insolvency for a long time.
3.44Making the case for a comprehensive review, the TMA also highlighted what it regarded as the ‘piecemeal approach’ to insolvency law reforms since the Harmer Report. The complexity of insolvency law:
…has been compounded by ad hoc reforms which have resulted in inconsistencies which make the processes unnecessarily time consuming and costly. The TMA's view, as previously raised with government, was that there were significant advantages in undertaking a holistic and thorough review of Australia's restructuring and insolvency framework by a suitably qualified and diverse panel of experts, with appropriate time and breadth taken to consider views of all stakeholders, using position papers, hearings and fuller submissions. We do not see much utility in ongoing bandaid solutions, which otherwise could be referred to as lazy regulation.
3.45The AICD, which argued in favour of a comprehensive review, also contended that approaches to reform since the Harmer Report had been ‘piecemeal’, and included in this category the introduction of Safe Harbour, the SBR regime, the FEG scheme, the COVID-19 moratorium, and steps to combat illegal phoenix activity:
These separate insolvency policy reforms over the past two decades have had distinct policy objectives with a number resulting in improvements in the regime and economic benefits, for instance the Safe Harbour. However, in totality the ad hoc and disjointed manner of reform has contributed to an insolvency regime that is increasingly complex and challenging for users, observers and regulators to navigate and oversee.
3.46The committee also received evidence from the Institute of Public Accountants, MinterEllison, SV Partners and Deloitte critical of the piecemeal approach to legislative reform in recent years and the complexity this had created, and calling, in various degrees, for a holistic review of insolvency law.
Economic and other changes since the Harmer Report
3.47In support of a comprehensive review, some witnesses also argued that economic and other changes in Australia since the Harmer Report made it necessary to consider if the policy architecture put in place in the early 1990s remained fit-for-purpose. For example, MinterEllison submitted that since the Harmer Report there had been ‘significant economic, technological and social change in Australia’, alongside growing complexity in Australia’s insolvency laws. Similarly, Professor Brand, SCoLA, noted that ‘much has changed in the economy, in business systems and in social attitudes to debt and insolvency’ since the Harmer Report, and the time was right for ‘significant wholesale referral of insolvency law to the ALRC’.
3.48Mr Murray and Professor Harris also pointed to changes in business practice since the Harmer Report as a relevant consideration. They submitted that:
…the change in business assets (from fixed assets to intangibles), the widespread use of business leasing (as opposed to outright ownership of plant and equipment) and the increasing levels of secured debt (both personal property security and often multiple levels of security over real property) challenges traditional notions of dealing with a financially distressed business with heavy plant and equipment and unencumbered assets that will help pay for insolvency processes.
3.49Professor Hargovan, SCoLA, said that in advocating for a major inquiry into both the policy and technical aspects of insolvency law, SCoLA joined ‘a steady chorus led by law reform bodies, judges and academics’. This was unsurprising, Professor Hargovan added, given the time that had passed since the Harmer Report and the problems arising from the ‘cycle of ad hoc reforms’ and ‘piecemeal tinkering’ since. While noting that the Harmer Report had led to ‘cutting-edge reform’:
…the world has changed since then, and we say a golden opportunity should be seized on this occasion to re-evaluate if our current insolvency system remains fit for purpose and remains competitive with other nations that have re-examined their insolvency systems.
Complexity and the division between personal and corporate insolvency law
3.50For many inquiry participants, a major driver of the complexity in the current system was the legislative, regulatory and judicial division between the corporate and personal insolvency systems. For some inquiry participants, a root-and-branch review was supported as a path toward simplification and harmonisation of Australia’s insolvency laws. This issue is considered in detail in chapter 5.
3.51It might briefly be noted here that while this inquiry’s focus was very much on Australia’s corporate insolvency system, calls for a comprehensive review in evidence to the committee were generally framed as a review of insolvency law in total—that is, corporate and personal insolvency.
Returns to creditors, the problem of deep insolvency, and insolvent trading
3.52Typically, when an insolvent company in Australia is liquidated, unsecured creditors receive minimal returns. Indeed, one headline statistic invoked at various points during this inquiry is that approximately 90percent of unsecured creditors get nil returns in a liquidation.
3.53As some witnesses pointed out, the insolvency system does not seek to guarantee creditors against loss. Asked what low returns to unsecured creditors said of the system, Treasury noted the ‘fundamental tension’ in insolvency law between managing the downside of risk-taking and allowing innovation and economic activity:
Looking at the history of insolvency law, going back to the 1200s, that has always been the tension that has existed. Insolvency law can deal with part of the challenge, which is to foster a smooth process and ensure that the process is understood, that it's predictable and it addresses the distribution of assets when failure occurs. What we don't have are laws that prevent people from being entrepreneurs and having a go, and we don't have laws that prevent people from experiencing losses. Losses can occur for a variety of reasons. Changes in the weather; you can have dramatic weather events that can generate losses. You can have unanticipated changes in market conditions. So out of that outcome there can be no assets left to distribute, and that's how you can find the outcome that you're describing which is there are zero cents in the dollar for some people at the end of the process.
3.54In response to a question about whether the current returns to creditors ‘meets with Australians’ expectations about the right to access the funds for the services or the goods that they've provided’, Mr Day, ASIC, noted the risk inherent in business meant creditors would often go unpaid in insolvencies:
I'm not saying it's right or wrong; I'm just saying often you will hear that refrain from the general public and obviously from small business, saying: 'Well, I've got to get paid. Who allowed this to happen?' The short point is: you're in business and you're taking on risk. If you're dealing with businesses, you're taking on risk. There are lots of checks and balances to try and minimise the impact or the occurrence of that. But can the system ever prevent that? The answer is no.
3.55Notwithstanding the above points, some witnesses suggested the low rates of return to creditors were indicative of broader failures in the system.
3.56A point repeatedly put in the inquiry was that many companies are so deeply insolvent by the time they enter administration there is neither a business left to restructure or proceeds remaining to distribute to creditors. Mr Winter, ARITA, asked about the low returns to unsecured creditors, explained the need to encourage access to earlier supports for companies in or approaching financial trouble:
While the statistic on that is easy to say—you've got 92 per cent that don't get paid—the principal cause for that is that directors, particularly in small to medium-sized businesses, do not get help early enough. So, by the time a liquidator arrives […] there is nothing left, and a lot of small-business people will get into the position where they go, 'I know I'm broke. I can't get more broke than broke, so I'm going to keep going, and perhaps the Powerball numbers will drop.' That means that you're in an absolutely negative situation.
3.57Associate Professor Wellard contended that changes in business practice, and in particular the ‘excessive or reckless incurring of debt’ and the prevalence of insolvent trading, made a comprehensive review of the insolvency system necessary. He suggested the issue of directors trading on their companies and incurring debt long past the point a business was viable should be ‘front and centre’ in any comprehensive review, given the damage it inflicted on creditors, the economy, and directors themselves:
In my view, the disenchantment we often hear about our insolvency system, whether it's liquidator remuneration or proceeds of preference claims not getting to creditors, is caused more by the reality that many company balance sheets are leveraged into oblivion well before a liquidator arrives on the scene. In short, you cannot get something from nothing.
3.58Detailing the extent of deep balance sheet deficiencies, and the resulting ‘abysmal returns to creditors’, Associate Professor Wellard submitted that the:
…‘corporate rescue’ narrative and associated reforms (important though they are) should not preclude a debate about what creditors, our economy and society legitimately expect from corporate failures and what, if anything, should be done about the prevalence of insolvent trading by directors of SMEs.
3.59The Australian Institute of Credit Management (AICM) also observed that unchecked growth in insolvent trading, and the failure to properly enforce insolvent trading rules, came at a direct cost to creditors. Such practices, it added, also reduced the chances of a viable company emerging from the insolvency process.
3.60The AICM pointed to the issue of creditor disengagement in insolvency processes, suggesting that this was driven by both complexity and poor returns. While the insolvency regime provides creditors with powers to challenge and approve decisions of insolvency practitioners, credit professionals:
…require a clear understanding of the process and legislation to have confidence to query an insolvency professional, challenge a decision or assert their rights. Due to the complexity of the current system this confidence can only be obtained with the benefit of legal advice which is not commercially viable for most creditors.
The impact of the complexity and cost of obtaining clarity is compounded by the fact creditors can generally expect little to no return from the insolvency, as evidenced by ASIC statistics in 2018-19 that showed in 96% of cases, the dividend estimate was less than 11 cents in the dollar.
3.61Scanlan Carroll contended that the operation of the unfair preference regime compounded the problem of poor creditor returns, particularly where trade creditors were also subject to unfair preference claims:
Often, the return to unsecured creditors at the beginning versus the end of protracted litigation does not change, it remains at zero cents on the dollar. However, the preference claim regime, if the defences are not applied correctly, can result in large portions of creditors of the company also subsequently entering into liquidation.
3.62In calling for a ‘single unified insolvency law’, ARITA suggested a new law should encourage ‘a turnaround and restructuring culture that is focused first on saving viable but distressed businesses’; and ‘enhance creditor outcomes by reducing unnecessary processes and other regulatory burdens’.
3.63Adding some context to the low returns to creditors, Mr Pearce, BLS LCA, noted that some businesses that may previously have provided returns were now able to avoid going into administration or restructure, which had some bearing on the statistics:
We introduced the safe harbour regime some years ago. The intention of that regime is to keep businesses out of administration where possible. To the extent you strengthen a solvent and informal restructuring regime so that those businesses don't go under in the first place, that's going to concentrate the businesses that fail on those that really weren't salvageable, and that should reduce the credit of return of businesses that go into administration—the fact that the ones that were providing quite high returns are now not going under at all.
3.64Mr Pearce added that an administration could involve complex and difficult trade-offs, and creditor returns were by no means the only relevant consideration. He discussed, by way of example, a hypothetical practitioner appointed to a company with some money in the bank:
[I]f you're appointed, do you trade on and try and save the business, potentially at the expense of employee creditors, so that the FEG scheme needs to be called on, or do you shut down everything, and everyone loses their jobs and all the trade creditors are unpaid but at least you've got some money to pay some creditors something? These are policy questions that are not easily answered.
Small business engagement in insolvency processes
3.65One concern raised by a range of inquiry participants was that administration was often too costly for SMEs to access. The committee also heard that SME directors may be reluctant to engage with an insolvency system that did not provide adequate restructuring and turnaround opportunities for SMEs experiencing financial difficulty.
3.66In its submission, the Australian Small Business and Family Enterprise Ombudsman (ASBFEO) argued that SMEs often face high costs in insolvency processes, and a lack of certainty regarding insolvency practitioner fees. MrBillson, ASBFEO, told the committee that SMEs, confronted with these high and uncertain costs, were reluctant to engage with the insolvency system. The insolvency process, he contended, is:
…not only about secured creditors but also about business owners who have put their life into it, employees who would love to see the business going, and investors who kind of wonder, 'Where's my spot in this conversation?' at times when significant proportions of residual assets end up going to the practitioner.
3.67The NSW Small Business Commissioner suggested SMEs were often reluctant to engage with insolvency practitioners in a timely manner out of concern the practitioner was incentivised to move quickly to a winding-up:
There is often a perception that as insolvency practitioners are paid through the restructuring process, they are incentivised to close businesses to pay creditors as quickly as possible. This perception, whether real or perceived, means some small businesses fail to act early and engage professional advice prior to their situation worsening.
3.68The availability and accessibility of restructuring options for SMEs was also raised as a potential issue with the current corporate insolvency system. MrBillson, ASBFEO, suggested the current insolvency system ‘is not sympathetic to honest failure and genuine prospects for recovery of the business or the business owner’.
3.69In late 2020, a new Part 5.3B was added to the Corporations Act (commencing 1 January 2021), which established a new formal debt restructuring process, known as Small Business Restructuring (SBR). This regime allows for financially distressed but viable small companies to restructure their existing debts so they can continue to trade, with the process to be supervised by Small Business Restructuring Practitioners. However, as discussed in chapter 7, the SBR regime has seen relatively low (albeit recently increasing) uptake, and inquiry participants were generally critical of the design and implementation process of the reforms, even when supportive of the intent.
‘Pulling down the shutters’: company deregistration
3.70A concern raised throughout the inquiry was the apparent prevalence of small business directors simply ‘pulling down the shutters’ and walking away from an insolvent company, rather than going through a formal insolvency process. Some inquiry participants suggested this practice was indicative of a system that was not fit for purpose. For example, SCoLA suggested the increase in deregistrations indicated some small business owners considered it better to abandon their companies and have them deregistered, rather than seek the appointment of a liquidator or administrator.
3.71On the oft-cited statistic that 13 out of 14 companies are simply deregistered rather than put through an insolvency process, Mr Winter, ARITA suggested this:
…says that our system is not fit for purpose, because the wholesale avoidance by deregistration shows that people are either too confused by what the regime offers or it's too complex and too hard for them to get into.
3.72The committee heard that the statistic of 13 out of 14 companies simply being deregistered should be understood in context. Not all companies left creditors unpaid—some, Mr Hathway, AIIP, told the committee, are simply businesses that quite appropriately ‘have a go, experiment with something, pay everyone off and go and deregister’.
3.73However, other inquiry participants raised concerns that companies were either: misusing voluntary deregistration procedures, falsely making the required claim of no liabilities, but without fear that claim would be properly scrutinised; or engineering a compulsory deregistration by ASIC, achieved by deliberately not lodging annual documents with the regulator. Deregistration, in this analysis, was potentially being abused to conceal misconduct and avoid creditors’ claims, not least outstanding tax debts.
Funding insolvency processes and the role of the state
3.74Another category of concerns raised in evidence was the apparent gaps in the funding of the work that is undertaken, or should be undertaken, in the corporate insolvency system.
3.75Currently, it appears insolvency practitioners undertake a significant degree of underfunded or unfunded work, with the cost of this work passed through the system through what some characterised as a cross-subsidisation model. In this sense, where an insolvency practitioner does engage in unremunerated work on a company with insufficient assets to cover their costs, some witnesses expressed the view that insolvency practitioners cross-subsidise this through higher charge out rates where assets can be realised. However, that view was disputed. This issue is explored in chapter 8.
3.76A range of inquiry participants also argued that the current corporate insolvency system failed to appropriately task or adequately fund the public interest functions of the system. In particular, inquiry participants contended that the corporate insolvency system does not adequately fund or otherwise provide for the orderly and consistent administration of insolvent companies with few or no assets. This issue, and the role of the state in resourcing the insolvency system, is examined in chapter 9.
Evidence on the strengths of the current system
3.77Not all witnesses were convinced of the need for a comprehensive review or thought the insolvency regime in need of fundamental reconstruction. KPMG suggested that Australia’s insolvency laws are ‘well-designed and operate efficiently and cost-effectively’. It added that it was ‘not aware of any empirical evidence that suggests that a significant change to our insolvency laws would result in any better outcome for insolvency businesses or their stakeholders’. KPMG therefore recommended ‘limited rather than fundamental change’, suggesting the:
…final reports and stakeholder submissions from recent reviews into safe harbour, schemes of arrangement, trading trusts and unfair preferences as we believe many of those recommendations represented sensible proposals for consideration.
3.78Asked about its position at a hearing, KPMG responded that while it was not resistant to change, it considered that the law was fundamentally well-designed and efficient, and ‘does allow, compared to international systems, for some quite rapid and cost-effective solutions’. KPMG pointed to the successful voluntary administration of Virgin Airlines, which, in an ‘extremely complex situation involving lots of parties’, saved the business. While acknowledging imperfections, KPMG maintained the current corporate insolvency system:
…works reasonably well. It allows for a rescue culture and pushes that forward, and that's got to be our main aim. Where a rescue is not possible, it provides for a relatively equitable allocation of the cost of business failure. It protects vulnerable creditors, employees being probably uppermost there. Where the company has completely failed, it allows for a relatively quick liquidation process, some investigation and the possibility of enforcement action. So, if you think about the basic tenets of an insolvency system and how they serve the economy, we think that the Australian system is fundamentally well designed.
Could it be improved? Certainly. Insolvency law, because it interacts with almost every other law of the land, needs to be constantly updated and revised to make sure that it keeps pace with the economy, with society's expectations and with changes in other laws around the country. That's why we end up with what I think has been described as a patchwork quilt of legislation which has been built up, which is complex and could be simplified, of course, but is almost a necessary evil because of the need to continually update the insolvency law to ensure that it stays relevant.
3.79The Australian Banking Association (ABA) argued that the committee should look to improve Australia’s corporate insolvency regime, rather than seek to replace it. It maintained that the current regime ‘still serves Australia appropriately’, even allowing that there were areas that could be reviewed to remove complexity, especially for small businesses:
The ABA's view is that it is appropriate to review and improve the current corporate insolvency regime, rather than replacing it. We believe that there should be support for reforms that make the law simpler and more cost effective to access. […] We certainly support a review to improve rather than replace the current system.
3.80It was put to the ABA that, as a body representing the views of secured creditors, its views contrasted with those put to the committee by unsecured creditors. The ABA responded by noting that changes to the system would have cost implications:
Yes, and I suppose, when you think of the unsecured versus secured, it's a balance of economics—that the more groups that are brought into preference or come up the stack in an insolvency then there's a cost to secured creditors for that, and so, if a secured creditor is going to receive less or is likely to receive less in an insolvency situation, there is a cost upfront to that, just balancing risk and reward.
3.81While Treasury did not argue against a comprehensive review, it did point to recent reforms as strengthening the insolvency system. Asked if the insolvency system, as it currently stood, was ‘fair and efficient’, Mr Dickson, Treasury, noted that one issue that had been raised was the stigmatisation of business failure that occurs—more so in Australia than in some overseas jurisdictions—and steps had been taken in recent years to address this and drive the long process of cultural change. Mr Dickson pointed, in this respect, to the introduction of the safe harbour for insolvent trading (which was ‘operating quite well and as intended’), the stay on ipso facto clauses, and recent new mechanisms such as simplified liquidation, as recent improvements.
3.82On whether the insolvency system was equipped to deal with what some fear will be a major increase in insolvency events, Mr Dickson responded that past experience suggested the system was robust:
With regard to the forecast, as people say, cliff of insolvencies, I've heard that forecast for a few years. It hasn't eventuated as yet, but one thing to note is that the insolvency system that we have today was the insolvency system that we had during the global financial crisis. If we're operating at roughly 4,000 or 5,000 insolvencies a year now, in the GFC it was above 10,000, so we've already operated in a time when we've had double the number of insolvencies. I would say that the system that we do have is robust and it does cope with peaks and troughs.
International comparisons
3.83Some inquiry participants pointed to international approaches to corporate insolvency that might be considered in Australia, including in the context of a comprehensive review process.
3.84ASBFEO, looking at the outcomes of the current insolvency system from the perspective of debtors (with a focus on SMEs) suggested that, relative to other countries, Australia’s is ‘considered to have one of the least debtor-friendly [insolvency] laws’. Ms Grazhdannikova, ASBFEO, told the committee that, from her background research on the matter, it appeared the insolvency system in Canada, and possibly the UK and Singapore, might be worth considering. ASBFEO explained that it had focused on Canada because the system, which took in both personal and corporate insolvency, assumed an ‘honest debtor’, and had a strong focus on providing business owners with an opportunity for a ‘fresh start’.
3.85Mr Hannan suggested that a comprehensive review should consider the types of insolvency appointments available in Australia, and the possibility of:
…Chapter 11 type proceedings, the UK voluntary arrangements procedures, prepacks or something like the system available in Canada under their Companies Creditors Arrangements Act for larger companies.
3.86Mr Barnden, CAANZ, argued that since the Harmer reforms, when Australia was regarded as a ‘world leader’ in insolvency reform, Australia had fallen off the international pace:
Other jurisdictions have implemented different types of restructuring and turnaround, and we should be looking at the world and also our backyard about what is available and how business has changed—both digitally and in the types of entities being used, whether it's trusts, partnerships or corporations. In implementing insolvency and reconstruction—because we want to put in there that we want to save businesses—legislation needs to be best fitted for the current market and the environment not only now but in the future.
3.87Professor Taylor drew the committee’s attention to the complexity of the Australian liquidation regime compared to that in place in New Zealand. Mr Murray supported this point, suggested ‘we tend to overcomplicate things in Australia in comparison with New Zealand’.
3.88King & Wood Mallesons argued that a holistic review of Australia’s insolvency laws should consider, among other things:
…the experience of reforms and [restructuring and insolvency] procedures implemented in relevant foreign jurisdictions, focusing specifically on the US, UK and Singapore, where in our view there are important learnings for prospective reform in Australia.
3.89TMA highlighted how Australia might learn for other jurisdictions that are viewed as ‘international leaders in restructuring and turnaround,’ such as the United States and United Kingdom. Those jurisdictions, TMA submitted:
…have designed and continue to develop and reform systems to promote corporate turnaround. TMA considers that it is important that reforms of this nature are considered as a part of a broader roots and branch review (discussed in more detail below) to ensure that Australia remains a leading jurisdiction for investment on an international stage.
3.90SCoLA, in support of its call for a comprehensive review, argued that Australia needed to ensure its insolvency regime remained internationally competitive:
Australia is in a global race for capital and insolvency law plays a foundational role in making a capital market attractive to international capital flows. Our fellow OECD members and other developed nations (in particular Singapore) have been active in reviewing and updating their insolvency and restructuring laws. Australia needs to ensure that our insolvency and restructuring laws are attractive to international creditors or Australian companies will face higher costs of capital and the community will suffer from businesses failing when they could have been saved.
3.91Other inquiry participants contended that Australia’s insolvency system was sound by international standards. For example, Treasury advised that in the World Bank Ease of Doing Business report, last published in 2019, Australia ranked 20th out of 190 countries for the category ‘resolving insolvency’.
3.92It might also be noted that the Productivity Commission’s 2015 report found that returns to creditors in Australian liquidations, while low, and the time taken to wind companies up, while long, were not inconsistent or generally worse than results seen internationally.
3.93Mr Gothard, KPMG, drew on his personal experience in suggesting that Australia’s corporate insolvency system compared well internationally:
There are many countries around the world, and I've experienced several of them, where a liquidation of a company or a restructuring of a company could take 10 or 15 or 20 years. That does not help anybody in any way. And for us to be able to have a system in place like voluntary administration, which can take a very complex situation, devise a restructuring plan, have it approved by creditors and have the business out of the process within 12 months or 18 months, is really quite an achievement on the international scale of things.
3.94KPMG submitted that while there was some room for improvement, Australia’s insolvency laws ‘operate efficiently and cost effectively compared to international systems’. KPMG further cautioned that international approaches would not always reflect community expectations, including ‘who should bear the risk of a company’s failure, the powers of creditors to influence outcomes which impact their return and the level of independent oversight applied’. It reasoned:
International approaches to insolvency and restructuring differ according to social purpose, economic goals, court systems and other jurisdictional legislation. While it is useful to learn from experiences in other jurisdictions, each country’s insolvency system is necessarily bespoke to its community standards and historical legal construct and therefore it should not be assumed that insolvency laws adopted in other countries can be easily imported into the Australian framework.
Other recent calls for a comprehensive and holistic review
3.95Calls for a comprehensive review received by this committee add to similar calls elsewhere. Notably, this includes the November 2021 statutory review of the insolvent trading safe harbour undertaken for the government by an independent panel. The Safe Harbour Review characterised Australia’s insolvency laws as an ‘impenetrable quagmire that is scary, complex and unknown’. It noted that calls for a holistic review of Australia’s insolvency laws was a ‘consistent theme’ in its report, and set out ‘some compelling reasons for a comprehensive review of Australia's insolvency laws from an economic, legal and social perspective’. Like participants in this inquiry, the Safe Harbour Review emphasised the economic and social change that had occurred since the Harmer Review, and highlighted the risks of addressing issues in one area of the law without considering the system holistically. It also suggested a review should consider the different challenges faced by SMEs compared to larger companies, noting a ‘one size model’ may not fit all.
3.96Also in 2021, the then President of the ALRC, the Hon Justice Sarah C Derrington AM, expressed support for ‘a comprehensive review of Australia’s insolvency laws to ensure they are “simple, efficient and effective”’. Justice Derrington set out how the ALRC would undertake such an inquiry, ‘and how it might be guided by the novel analysis methods developed by the ALRC during its current inquiry into the law on financial services and corporations’.
Committee view
3.97In the committee’s assessment, Australia’s corporate insolvency system is overly complex, difficult to access, and creates unnecessary cost and confusion for both debtors and creditors.
3.98Tellingly, few parties seem satisfied with the system as it stands. Unsecured creditors are understandably frustrated by stubbornly low returns in insolvency processes. Debtors, particularly smaller businesses, regard opportunities for restructure as lacking and system costs as excessive. Insolvency practitioners and other observers consider the system is not appropriately resourced to achieve its purposes. A very large number of stakeholders and experts, meanwhile, appear to agree with the Safe Harbour Review’s assessment of the system as an ‘impenetrable quagmire’.
3.99While reforms introduced following the Harmer Report were, as one witness put it, ‘cutting-edge’ at the time, the committee is concerned that Australia’s insolvency system may no longer reflect modern business practice or sufficiently meet business needs. This is particularly the case for smaller and medium-sized businesses. It also appears that the insolvency system has not kept pace with changes in the Australian and global economy since the Harmer Report, including but not limited to the shift from fixed assets to intangibles and increasing levels of secured debt. The committee also notes evidence suggesting Australia may have also fallen off the international pace in terms of insolvency reform.
3.100Since the post-Harmer Report reforms of the early 1990s, a great number of changes have been made to corporate insolvency law. Many of these reforms have made valuable contributions to the corporate insolvency system; indeed, assessed individually, they overwhelmingly appear worthwhile and sensible. Moreover, it almost goes without saying that the law should respond to changing circumstances, and seek improvements where failings are identified. However, the committee agrees that the approach to corporate insolvency law reform in recent years has been, at times, ‘piecemeal’ in nature, with reforms attending to parts of the insolvency system without always having regard to the whole. This has added to the complexity and, in places, inconsistency in the system, making it harder and more costly for all to navigate. The committee also notes how failings in one area—for example, the apparent extent of insolvent trading and lack of enforcement in response—creates pressures throughout other parts of the system.
3.101Even where relatively modest changes to the law might be worthwhile (and elsewhere in this report some such changes are recommended) specific amendments to the law are unlikely to resolve the fundamental issues set out in this chapter. The committee has concluded that, as a first step to addressing the shortcomings of the corporate insolvency system, there is a need for an independent and comprehensive review that addresses the system as a whole.
3.102As will be explained further in chapter 5, the committee is of the view that a holistic review should have regard to both corporate and personal insolvency.
3.103The committee considers that the comprehensive review should begin as soon as practicable. The committee suggests that tasking an existing body (supplemented with other specialist skills) would enable the comprehensive review to proceed in a timely way.
3.104The committee recommends that as soon as practicable the government commission a comprehensive and independent review of Australia’s insolvency law, encompassing both corporate and personal insolvency. The committee is also recommending that the government progress several other near-term actions as identified in the executive summary.
3.105The next chapter in this report will consider what a comprehensive review might look like, including its structure, scope, and processes. Chapter 5 then considers, among other things, the data required to support a comprehensive review.