Chapter 11Assets of the company and creditors' priority
11.1This chapter is the first of four chapters covering the assets of the company and creditors' priority. The introductory section provides some background on the liquidator's tasks relating to the company's assets and creditors' priority. The last part of the introductory section provides an outline of the remainder of this chapter and the remaining three chapters of the report.
Introduction
11.2When conducting a liquidation of a company, liquidators are required to identify all the company's property—in order for it for to be realised and for the proceeds to be distributed to creditors. The liquidator's tasks include:
protecting, collecting and selling the company's assets;
investigating and reporting to creditors about the companies affairs, including;
voidable transactions and unfair preferences (payments made to certain creditors over others) that may be recoverable;
possible claims against the company’s officers (including insolvent trading);
creditor-defeating dispositions that may be recovered, including in relation to illegal phoenix activity;
inquiring into the failure of the company; and
distributing money from the collection and sale of assets in the following order:
payment of the costs of the liquidation, including the liquidator's fees (subject to the rights of any secured creditor);
secured creditors where they hold a security interest typically over non-circulating assets (such as plant, equipment, and real estate);
employees as priority unsecured creditors (with funds coming principally from circulating assets e.g. inventory) in the following order;
(i)outstanding employee wages and superannuation;
(ii)outstanding employee leave of absence (including annual leave and long service leave);
(iii)employee retrenchment pay; and
then to other unsecured creditors.
11.3Each category of creditor must be paid in full before the next category is paid. If there are insufficient funds to pay a category in full, the available funds are paid on a pro-rata basis—with the implication or flow on effect being that the next category of creditors in line will not receive any funds.
11.4The priority principle is a departure from the pari passu rule that unsecured debts should be treated equally. TheCompanies Act 1883 (UK)introduced the priority to company law.It recognises that, unlike other creditors, employees are typically unable to shield themselves from the risk of their employer’s insolvency (for example, employees generally devote all their human capital to one employer, cannot diversify risk, cannot take security for their debts, and do not have the same access to financial information).
11.5Creditors might be owed money because they supplied goods or services to the company, made loans, paid for goods or services that they have not received, or are an employee owed money for unpaid wages and other entitlements. Creditors might be secured or unsecured:
A secured creditor holds a security interest, such as a mortgage, in some or all of the company’s assets to secure a debt owed by the company. Lenders might require a security interest in company assets when they provide a loan. If the creditor wants to ensure their security interest over personal property other than land is enforceable and given priority in insolvency, they generally register the security on the Personal Property Securities Register (PPSR).
An unsecured creditor does not hold a security interest in the company’s assets.
11.6The assets available to the liquidator fall into four broad types:
(1)circulating assets of the company that are available to unsecured creditors through the priority process;
(2)non-circulating secured assets of the company that are available to secured creditors;
(3)assets that may be recovered from voidable transactions and unfair preferences; and
(4)assets involved with trust structures.
11.7For an insolvent company, a large portion of the liquidator's work involves the collection and sale of circulating and non-circulating assets and the subsequent distribution of funds to creditors to recycle those assets into more productive uses in the economy. However, for deeply insolvent companies, there may be few, if any, circulating assets and any non-circulating assets may have a high level of secured interests. Consequently, in such deeply insolvent cases, a higher portion of the liquidator's work involves recovering voidable transactions and unfair preferences. In situations where trusts have been used as a significant structure in a business, an increased share of the liquidator's work will be associated with assets that are held in trusts.
11.8The remainder of this chapter and the following three chapters of this report consider the issues that arise when liquidators seek to realise each asset type, and related questions regarding the overall operation of the corporate insolvency regime, as follows:
(a)this chapter covers circulating assets that belonged to the company at the commencement of the liquidation and existing and proposed mechanisms for establishing the priority of creditors over unsecured assets;
(b)chapter 12 considers the personal property securities regime intended to facilitate the handling of secured assets;
(c)chapter 13 addresses voidable transactions and unfair preferences; and
(d)chapter 14 examines issues for assets held in trusts.
Assets of the company
11.9Circulating assets were the main type of unsecured company asset that submitters and witnesses raised with the committee. This section provides:
background on circulating assets;
views of inquiry participants on the Whittaker Review recommendations on circulating assets; and
other issues raised by submitters and witnesses.
Background on circulating assets
11.10In its submission, the Attorney General’s Department (AGD) explained how the Personal Property Securities Act 2009 (PPS Act) introduced the concepts of circulating assets and non-circulating assets:
The circulating asset provisions in the PPS Act are also particularly relevant in a corporate insolvency context because they affect the size of the asset pool available for sale and distribution. Prior to the introduction of the PPS Act, it was common for a lender to a corporation to take a fixed and a floating charge over the corporation’s assets. The fixed charge would typically be taken over the company’s major assets such as plant and equipment, whereas the floating charge would be taken over inventory or other assets that may typically turn over in the ordinary course of the company’s business.
11.11The PPS Act removed the distinction between fixed and floating charges and instead created the concept of a non-circulating asset (to mirror collateral over which a fixed charge would traditionally have been taken) and a circulating asset (to mirror the type of collateral over which a floating charge would traditionally have been taken). The corresponding provisions in the Corporations Act 2001 (Corporations Act) were updated to reflect this change.
11.12The PPS Act also provides that an asset that might otherwise be a circulating asset might be deemed to not be a circulating asset if the secured party has control of the asset and, has registered a financing statement concerning the collateral on the Personal Property Securities Register (PPS Register), disclosing that it has control over the asset.
11.13The relevant sections of the PPS Act are Sections 340 to 341A, which set out the meaning of a circulating asset. The Whittaker Review (discussed in Chapter 13) noted that those sections are very detailed and technical and, at times, difficult to apply. Several submissions to the Whittaker Review described these provisions as being unnecessarily complicated and suggested that they be restructured. The Whittaker Review also noted that:
The same submissions pointed out that the concepts of ‘circulating asset’ and ‘circulating security interest’ draw distinctions that are based on whether the grantor or the secured party has title to the affected assets, or has ‘control’ of them. The submissions noted that this is inconsistent with the general approach of the Act, which is to de-emphasise the location of title and to look more to the underlying commercial substance of an arrangement to determine its legal effect.
11.14Whether or not an asset is a circulating asset is significant if a corporate grantor becomes insolvent. Suppose the personal property falls within the definition of a circulating asset, the statutory priority afforded to employee creditors under the Corporations Act will apply where unsecured asset realisations are insufficient to meet employee claims. For non-circulating assets, the secured party may have recourse against the property in accordance with its priority.
11.15Section556 of the Corporations Act establishes the priority for debts and claims that 'must be paid in priority to all other unsecured debts and claims', which includes employee claims. Employee claims are also prioritised under Section561 of the Corporations Act over circulating assets (which is contingent on insufficient unencumbered assets to meet employee claims). Therefore, Section 556 applies to unsecured assets, while Section 561 applies (for employee claims) to circulating assets.
11.16Mr Michael Murray and Professor Jason Harris noted that employees and, therefore, the Fair Entitlements Guarantee (FEG) has priority over the company's circulating assets – such as work-in-progress payments and receivables. The liquidator must take care to use such assets with that priority in mind, coupled with uncertainty as to the extent of the priority of the liquidator's remuneration.
11.17Mr Murray and Professor Harris clarified that, historically employees were given priority for their wages over floating charge assets of an insolvent enterprise dating back to the 19th century. Mr Whittaker expanded on the history of the priority in his evidence to the committee, stating:
My understanding is that the original policy objective behind the statutory priority that is afforded to employees over floating charge assets was developed in England during the Industrial Revolution, in the context of a manufacturing business that granted a fixed and floating charge over its assets to its bank. The view was taken that factory workers, whose labours produced the inventory that the company would subsequently sell, should be entitled to priority in relation to the inventory to recover their unpaid wages, rather than leave them exposed to the risk that their efforts could produce the inventory but that they might not be paid for their work because the proceeds of sale of the inventory had been claimed by the bank that held the security. It is also said that employees deserve particular protection because of their vulnerability, and their inability to protect themselves from the consequences of the insolvency of their employer.
The desirability or otherwise of protecting employee entitlements from an employer’s insolvency, and the most appropriate way of doing this, continues to be a topic of discussion as a matter of corporations law policy.
Whittaker Review recommendations
11.18Mr Whittaker indicated that it was not the role of his review to express a view on the policy behind Section 561 of the Corporations Act. However, the Whittaker Review concluded that Sections 340 to 341 of the PPS Act should be restructured based on support from respondents and made the following six recommendations:
Recommendation 356: Sections 340 to 341A be amended so that collateral is only a circulating asset of a grantor if it is in the inventory of the grantor or its proceeds.
Recommendation 357:Section 340 to 341A, be removed from the PPS Act and relocated to the Corporations Act.
Recommendations 358–361: to clarify the circumstances in which an account in an Authorised Deposit Taking Institution (ADI) is a non-circulating asset, registration requirements and when an ADI or secured party has control and priority.
Issues raised by submitters and witnesses
11.19The committee heard various concerns about the complexity and need for legislative clarity for provisions on the relative priority of liquidator remuneration and employee entitlements over circulating assets.
11.20The Business Law Section of the Law Council of Australia (BLS LCA) drew attention to the issue on who has priority over circulating assets. Some interpretations of section 561 of the Corporations Act have the effect of putting liquidators behind both employees and security holders. In the United Kingdom (UK), this issue came to a head following a decision of the House of Lords in the case of Leyland DAF v Talbot [2004] UKHL9 that liquidator fees did not have priority. This decision then led to amendments to the UK equivalent of section 561, reversing the position and prioritising liquidator remuneration (including general costs and remuneration). Considering the decision and the legislative amendments in the UK, the BLS LCA recommended amendments are made to the Corporations Act— in particular sections 433 and 561— to provide clear priority to insolvency practitioners for payment of external administration costs and expenses.
11.21Also identifying applicable case law in this area, the Association of Independent Insolvency Practitioners (AIIP) discussed in its submission to the inquiry, the continuing disagreements between liquidators and the FEG in relation to sections 561 and 556 of the Corporations Act: FEG:
Universal Distributing Co. Ltd (In Liq) (1933) 48 CLR 171 allows the liquidator to be paid for time incurred in securing, preserving and realising assets, but this does not extend to general expenses (such as statutory tasks like investigations, reports filed with ASIC and reports prepared for creditors etc).
So at present, employees (and in their stead the Government body under the Fair Entitlements Guarantee) stand ahead of the costs incurred by a liquidator for completing statutory tasks like investigations, reports filed with ASIC and reports prepared for creditors etc).
There is often disagreement between FEG and registered liquidators on the correct interpretation of the Corporations Act in relation to both Sections 561 and 556. In brief, where there are insufficient assets to pay creditors in full from circulating assets, FEG requires that the whole of the proceeds are paid to FEG with some modest allowance for the direct costs of realisation, but not general expenses.
11.22Mr Michael Murray and Professor Jason Harris suggested that amendments to the legislation or regulatory guidance on the expectations of external administrator's use of circulating assets and proceeds to fund trade-on activity would provide much needed clarity to the law. Mr Murray and Professor Harris also suggested that providing clear priority to insolvency practitioners for payment of their remuneration and expenses is required in the context that remuneration is also subject to legal uncertainty, an issue in which was discussed in more detail in Chapter 8 of this report.
11.23The Turnaround Management Association (TMA) recommended that consideration be given to adopting the recommendations in the Whittaker Report regarding circulating assets or making other reforms streamline circulating asset provisions. The TMA suggested that the policy intent behind the priority afforded to employees (and administrators) be reconsidered and consideration be given to whether there is a more efficient manner to achieve those policy goals.
11.24The Australian Restructuring Insolvency and Turnaround Association (ARITA) noted that it and many registered liquidators and restructuring lawyers take the view that the purpose of section 561 of the Corporations Act is to protect employees from the secured creditor and not to give employees entitlements a super priority over liquidation costs and section 556 priorities. Hence, ARITA suggested that the law be amended to ensure that the approved remuneration and reasonable expenses of liquidation should be paid out of any circulating assets before the distribution to employees or creditors with security over such circulating assets.
11.25KordaMentha also argued that the purpose of Section 561 is to protect employees from a secured creditor with security over circulating assets, not to give employees a super priority over the costs of the liquidation and the normal Section 556 priorities. KordaMentha suggested it does not make sense that if there is no secured creditor, a liquidator's costs and remuneration are paid in priority to employees, but the existence of a secured creditor on the appointment, somehow displaces that priority such that a liquidator's general costs are subordinated to employee claims.
11.26McGrath Nicol raised similar concerns about circulating assets and encouraged further legislative clarity, such as:
Improving statutory clarity on the scope of circulating assets and priority;
issuing guidance on expectations for practitioners dealing with the FEG
Recovery Program;
using legislative reform in preference to complex legal appeals; and
FEG funding expansive requests for information from insolvency practitioners.
11.27In contrast to the above suggestions, the Department of Employment and Workplace Relations (DEWR) held a different view. DEWR noted that the preference for employees over circulating assets described in Sections 433 and 561 of the Corporations Act is a modern iteration of a provision in insolvency legislation dating back to the Preferential Payments in the Bankruptcy Amendment Act 1897 (UK). DEWR indicated that the priority entrenches the principle that a secured party should not enjoy the realisation of floating assets (e.g. receivables, trading stock) generated on the back of employee labour before employee claims are satisfied. This preference only applies where ‘free’ asset realisations are insufficient to meet employee claims.
11.28DEWR noted that while considering some aspects of circulating assets, the Whittaker Review did not address some of the complexity and uncertainty with Section 561 of the Corporations Act. To resolve the uncertainty, DEWR suggested that the committee consider reforms to ensure the legislation effectively achieves the longstanding policy objective that certain employee entitlements have priority ahead of the claims of circulating security interest holders. Such reforms would strengthen the recoverability of FEG and reduce the impost borne by the taxpayer. DEWR indicated that to ensure that circulating assets are preserved for the benefit of priority employee creditors, areas for reform may include:
the definition of circulating assets within the meaning of the PPS Act;
the uncertain operation of sections 433 and 561 of the Corporations Act;
inefficiencies of liquidating trusts with corporate trustees;
codify the High Court’s 2019 decision in Re Amerind;
whether the priority regime set out in the Corporations Act should apply to partnerships;
whether the treatment of trade-on losses should be aligned with trade-on profits; and
in relation to pooling orders:
whether pooling orders should apply to secured debts.
whether, where a group subject to a class order goes into liquidation, they should be treated as a pooled group; and
whether the persons who have standing to apply for a pooling order should be clarified.
11.29The BLS LCA suggested that recommendations on moving circulating asset provisions to the Corporations Act might be considered as part of the broader review of harmonisation of insolvency laws.
The BCA National Training Case
11.30In April 2023, the NSW Supreme Court decision, In the matter of BCA National Training Group Pty Ltd (in liq) [2023] NSWSC 366 (the BCA National Training Case) clarified some aspects of the relative priority for employees and liquidators over circulating assets.
11.31This matter, between Mr Tonks as liquidator of BCA National Training Group Pty Ltd (in liq) (BCA NT) and the Commonwealth of Australia represented by DEWR, disputed the application of Sections 556 and 561 of the Corporations Act in the distribution of funds in the winding up of the company. Mr Tonks contended that his remuneration and expenses ranked in priority to claims of preferred creditors under paragraphs 556(1)(e), (g) or (h), while the Commonwealth argued that preferred creditor claims must be paid out first under Section 561.
11.32The NSW Supreme Court decision favoured the liquidator. Justice Black highlighted that a primary contention made by the Commonwealth failed because there was ‘no contest between claims of a secured creditor and the claims of preferred creditors over the Company’s circulating assets and no application of circulating assets to meet a claim of the secured creditor in a manner inconsistent with section 561 of the Act’.
11.33Key points from the NSW Supreme Court decision are as follows:
The case highlights the contingent nature of section 561 of the Corporations Act.
Section 556 provides the priority regime which deals with contests between liquidator’s remuneration and expenses and employee preferred creditor claims, not section 561.
Section 561 deals with contests between the secured creditor’s claim to circulating assets and employee preferred creditors’ claims. Section 561 may be a priority regime, but only in respect of access to circulating assets, as between the secured creditor with security over circulating assets and preferred creditors, only upon the insufficiency of assets.
Committee view
11.34The committee notes the Whittaker Review recommendations on restructuring circulating asset provisions 341 to 341A in the PPS Act were widely supported at the time of that review.
11.35However, the Whittaker Review did not make recommendations on circulating asset provisions in sections 556 and 561 of the Corporations Act. As noted above, section 561 protects employees from a secured creditor with security over circulating assets and, in doing so, may have given employees priority over liquidators in the past. The committee notes that liquidators have argued that the law should be amended to provide them with priority over employees in such cases, citing similar changes in the UK. The committee notes that the DEWR has argued for employees to retain priority. The committee also observes that some aspects have been clarified by the recent NSW Supreme Court decision in the BCA National Training Case.
11.36The committee considers that if the relative priority of employees and liquidators over circulating assets under section 561 of the Corporations Act is to be considered further, that should be done as part of a comprehensive review because:
the current policy position behind section 561 is based on a principle that dates back to the Industrial Revolution;
the Whittaker Review did not consider or make a recommendation on the Corporations Act circulating asset provisions; and
such a policy issue needs the kind of detailed consideration and consultation that a comprehensive review can provide in light of recent court decisions.
11.37The committee recommends that the comprehensive review consider the relative priority of employees, liquidators, and secured creditors, including the priority over circulating assets under section 561 of the Corporations Act 2001. The committee further recommends that this be a high priority topic for the comprehensive review.
Other mechanisms relating to creditors' priority
11.38This section covers existing and proposed mechanisms for establishing creditors' priority raised during the inquiry for employees and subcontractors. The four mechanisms are:
the Fair Entitlements Guarantee;
independent (employee-like) contractors;
worker entitlement funds; and
security of payment reforms for subcontractors.
The Fair Entitlements Guarantee
11.39The Fair Entitlements Guarantee (FEG) is a legislative safety net scheme of last resort with assistance available for eligible employees. The FEG is established by the Fair Entitlements Guarantee Act 2012 (FEG Act), regulated by the Fair Entitlements Guarantee Regulations 2022, and is administered by the DEWR. The intention of the FEG, as set out in the Explanatory Memorandum to the bill, is to:
…fulfil a significant community need to protect the entitlements of Australian employees who would otherwise stand to lose their entitlements if they lose their jobs due to insolvency of their employer. While alternative measures for protecting employee entitlements are available on a limited scale (for example, redundancy trust funds in the construction industry) these are insufficient to adequately protect employees.
The primary objective of the Bill is to provide a scheme for the provision of financial assistance (called an ‘advance’) to former employees where the end of their employment is linked to the insolvency or bankruptcy of their employer. After making an advance, the Commonwealth assumes the individual’s right to recover the amount that was advanced through the winding up or bankruptcy process of their employer.
11.40The FEG eligibility requirements include that:
the person’s employment has ended;
the end of the employment is linked to the insolvency of their employer;
the employer is in liquidation or bankruptcy; and
the person has unpaid employment entitlements that cannot be obtained from another source.
11.41Financial assistance under FEG (called an FEG advance) is available for the following employee entitlements— all of which are subject to a maximum weekly wage that caps the weekly rate at which outstanding employee entitlements are paid (currently $2,585 per week):
unpaid wages (up to 13 weeks);
unpaid annual leave;
unpaid long service leave;
payment in lieu of notice (up to 5 weeks); and
redundancy pay (up to 4 weeks per full year of service).
11.42The FEG does not cover unpaid superannuation guarantee contributions required to be paid by employers under superannuation law.
11.43The FEG and its predecessor programs have advanced approximately $2.98billion (as of 30 June 2022) to around 236,000 claimants. Liquidations (as distinct from bankruptcies) account for more than 99.5 per cent of expenditure on FEG advances.
11.44The FEG also has a recovery program that undertakes the following activities:
Providing recovery funding for liquidators to enable recovery efforts, including legal proceedings, to recover FEG advances that liquidators would not otherwise have resources to pursue.
Acting as an active creditor, the FEG seeks to minimise or prevent FEG claims from arising, increase returns to the Commonwealth and positively influence outcomes in liquidations through early intervention and active monitoring of insolvencies.
Using policy, governance and reporting to influence and enhance legal frameworks and policy settings.
11.45Since 2000-01, overall dividend recoveries for the FEG and its predecessor programs total approximately $615 million. Since the establishment of the FEG Recovery Program in 2015, DEWR has recovered approximately $426 million in dividends. $232.6 million of these recoveries are directly attributable to the Recovery Program, amounting to 54 percent of overall recoveries over this period. These directly attributable recoveries represent a return on investment of 514% for the Recovery Program over its lifespan.
11.46DEWR noted that theCorporations Amendment (Strengthening Protections for Employee Entitlements) Act 2019(SPEE Act) was enacted in response to evidence that certain employers and parties associated with them were deliberately structuring their business affairs using sharp corporate practices to avoid paying employee entitlements when their business entered winding up, resulting in inappropriate reliance on the FEG to pay outstanding employee entitlements. DEWR noted that:
These practices hurt all Australians – including small business creditors through lost payments for goods and services already supplied, employees through lost wages and superannuation entitlements, and ultimately Australian taxpayers through not only [the] burden borne by the FEG, but also through lost taxation revenue. In addition, those who pursue these practices gain an unfair advantage over honest competitor businesses who comply with their legal obligations to pay their debts. This has a broader economic impact.
11.47The SPEE Act addressed concerns about sharp corporate practices by:
Strengthening the operation of provisions at Part 5.8A of the Corporations Act to better deter the avoidance of employee entitlements and to protect such entitlements from agreements or transactions that would operate to defeat their recovery.
Allowing contributions to be sought from certain entities in a corporate group or entities with a closely connected economic relationship, for the payment of outstanding employee entitlements of an insolvent company, in limited circumstances.
Introducing new provisions to disqualify company directors and other officers with a track record of involvement in corporate contraventions and insolvencies where the FEG has been inappropriately relied on.
11.48DEWR suggested that to further advance the last resort objectives of the FEG, it would be useful to examine whether:
the threshold for the director disqualification provisions remains appropriate;
the requirements for making employee entitlements contribution orders are appropriate; and
amendments are necessary to prevent novel uses of schemes of arrangements from compromising the integrity of the FEG.
The Ovato case
11.49The Australian Manufacturing Workers' Union (AMWU) and the Australia Council of Trade Unions raised concerns about a case in which a company called Ovato had made novel uses of schemes of arrangement to shift the burden of employee entitlements onto the FEG. The AMWU summarised its concerns as follows:
In 2020, citing the COVID-19 pandemic and digitalisation trends as both negatively impacting revenue, the company initially sought negotiation with the AMWU and its members to navigate the pressures of maintaining operations and remain solvent. Facilitated by the Fair Work Commission, the AMWU, its members and Ovato agreed to reduce the work volumes of the company, with workers agreeing to reduce work hours by 40%, with the commensurate loss of pay. Negotiations went on for months in early 2020.
While workers assisted by agreeing to reduce hours, forfeiting overtime and making necessary adjustments to ensure the viability of the Company, Ovato secretly sought advice from highly resourced advisors to restructure its finances in a manner that would allow it to reduce its redundancy obligations to its employees and readjust their balance sheet. The subsequent restructuring allowed the company to effectively offload the obligation to pay redundancy entitlements from the company to Fair Entitlement Guarantee (FEG) Scheme.
In November 2020, this restructure was announced by Ovato to the ASX. This had not been disclosed to the AMWU who were negotiating in good faith to secure the future of the company.
11.50In its submission, DEWR provided information on the issues arising from Ovato case. Members’ schemes of arrangement, such as that used in Ovato, are typically utilised outside of insolvency contexts to effect change of control transactions, such as acquisitions and mergers. The novel use of members’ schemes of arrangement to undertake a restructuring, such as that in the Ovato Group, exposed shortcomings in the legal framework design to prevent misuse of the FEG. This poses significant challenges to the integrity of the FEG and exposes the Commonwealth to financial risks. DEWR made the following observations about the Ovato case:
In 2020, the Ovato Group implemented a restructure that aimed to consolidate its printing production capacity, improve its operating efficiencies and reduce its cost base, making it more sustainable and enabling a return to profitability.
As part of the restructure, four members’ schemes of arrangement transferred assets and liabilities within Ovato Group companies, resulting in unviable entities that were left with employee entitlement liabilities and then wound up. This was done with the express intention of relying on FEG to fund these liabilities, while assets were shifted to other entities within the Ovato Group that continued to trade. 205 employees retained in the wound-up entities were made redundant, with the bulk of their unmet employee entitlements funded through FEG - $16.4 million in FEG advances was paid to 205 claimants. On 13 October 2022 the liquidator for Ovato Group paid a dividend of $1.875 million to the department, representing a return of 11% of FEG advanced.
On 21 July 2022 voluntary administrators were again appointed to the Ovato Group, which comprised 59 corporate entities. At the date of the appointment of the voluntary administrators, the Ovato Group employed approximately 485 employees. On 14 September 2022, the IVE Group completed its acquisition of substantially all of the printing and finishing assets of the Ovato Group. A number of former Ovato Group employees will transfer their employment to the IVE Group. However, those not transferring to IVE Group have already (or will be) made redundant and will seek assistance from FEG to be paid their unmet employee entitlements. As at 30 November 2022, the department has received FEG claims from 177 redundant employees seeking payment of up to $12.47 million in unpaid employment entitlements, with further claims anticipated over coming months.
11.51The Australian Securities and Investments Commission (ASIC) advised that it had been monitoring schemes of arrangement to identify whether the novel features of the Ovato schemes of arrangement are being repeated. To date, ASIC has not identified any similar schemes that have been proposed and does not plan to publish any further guidance at this stage.
11.52In its submission, DEWR noted that independent contractors who do not hold a security interest in an insolvent company’s assets would be ordinary unsecured creditors in a liquidation. The debts owed to ordinary unsecured creditors do not enjoy the priority afforded to employee entitlements under the Corporations Act. In a practical sense, independent contractors will find it more challenging than employees to recover any outstanding payments owed by an insolvent principal. DEWR noted the example of the winding up of Foodora in 2018, in which there were reports that independent contractors accepted payments that fell short of the full amounts owing to them due to the difficulties and delays associated with taking action to pursue money they were owed.
11.53DEWR noted in its submission that the government is considering reforms to strengthen protections for independent employee-like contractors. Before the federal election in May 2022, the government committed to empowering the Fair Work Commission to inquire into and set minimum standards in employee-like work, such as independent contracting in the gig economy. The government is currently consulting stakeholders on how to implement this commitment.
Worker entitlement funds
11.54A Worker Entitlement Fund (WEF) is for employees' long service leave, sick leave or redundancy payments. These WEFs are also referred to as redundancy trusts or redundancy funds. Although WEFs operate in a variety of ways, their purpose is to manage employee entitlements and provide portability and protection. WEFs recognise the transitory nature of employment in certain industries.
11.55WEFs provide for the portability of worker entitlements that may not otherwise exist, particularly in project-based industries like construction, where workers may have dozens of employers during their careers. WEFs are typically established as joint ventures between industry parties (that is, unions and employer associations) and often involve the creation of a trust with a corporate trustee. The directors of the trustee companies are usually drawn from industry parties with representatives of employers and employees. An entity can apply to the Commissioner of Taxation for endorsement to be an approved WEF or to operate an approved WEF.
11.56An employer can make regular contributions to a WEF on behalf of their employees. When an employee ceases employment with an employer who is contributing, then the employee may be entitled to receive a payment from the WEF. This is dependent upon the types of contributions and the terms of the applicable awards and industrial agreements.
11.57Examples of WEFs include:
Incolink;
Australian Construction Industry Redundancy Trust:
Contracting Industry Redundancy Trust;
Building Employees Redundancy Trust;
Plumbing & Pipe Trades Entitlement Fund; and
Tasbuild.
11.58Incolink participated in the inquiry, drawing attention to the use of WEFs to protect workers when insolvencies occur. Incolink noted that because of the high number of creditors and the priority rules that apply to creditors when a business can no longer trade, benefits that were owed to workers often go left unpaid, unless a WEF is available.
11.59Incolink noted the WEFs are complementary to the FEG in that they:
cover some of the gaps between an employee's actual entitlements, which can often be significantly higher than the coverage of entitlements by the FEG; and
can provide rapid support to employees, while the FEG processes can take many months.
11.60Certain contributions made to an approved WEF are exempt from fringe benefits tax (FBT) (also known as an exempt benefit). Contributions to an approved WEF are defined by Commonwealth, state and territory laws and may include redundancy payments, long service leave, and sick leave.
11.61Incolink proposed reforms to make legislative changes to fair work and fringe benefits legislation to enable employers to make annual leave contributions to WEFs:
The idea is that all contributions of whatever nature (redundancy, insurance premiums for IPT and PSLi, training and support levies, and other member benefits) will be exempt from FBT, provided that it is part of an agreement (not necessarily an [Enterprise Bargaining Agreement (EBA)], and the contribution is to fulfill the employer’s obligation under that agreement. It should be noted that there are many employers who see the benefit of making contribution on behalf of their workers to provide them with the needed safety net but also it allows employers to transfer their entitlement liability to a third party such as Incolink. This way, each industry can maintain a single fund that deals with all product lines and allows for contributions from both EBA and non-EBA arrangements, therefore expanding the scope of each fund and increasing the contribution pool for investments back into each industry.
Security of payment reforms for subcontractors
11.62The Murray Review of the Security of Payments in 2017 identified legislative best practices with a view to improving consistency in the security of payment legislation and the level of protection afforded to construction industry subcontractors to ensure they obtain payment for work they have completed, or for goods and services they have supplied.
11.63Over the past 18 years, every state and territory government has progressively enacted security of payment legislation to facilitate prompt progress payments. Other than Western Australia (WA) and the Northern Territory (NT), all jurisdictions have based their legislation on the New South Wales (NSW) legislation and have come to be referred to as the ‘East Coast model’. The legislative regimes that operate in WA and the NT are based on a different model, referred to as the ‘West Coast model’. There are significant differences, not only between the two models but also within those jurisdictions that have adopted the East Coast model.
11.64The Murray Review identified significant problems associated with the current security of payment legislative regimes, such as:
None of the existing state and territory legislation (except for Queensland) provides any effective security of payment where a party higher up the contractual chain becomes insolvent.
The legislative regimes are unduly complex, and this has discouraged their usage and caused confusion.
There are questions about the process of appointing adjudicators; the adequacy of the profession’s qualifications, training, and grading; and the variable quality of adjudication decisions.
There is an imbalance of bargaining power within the contractual chain. Passing on contractual risks has resulted in the imposition of unfair contract terms to prevent payment to the party carrying out construction work.
There are suggestions that head contractors' intimidation and retributive conduct discourage subcontractors from pursuing their entitlements.
Late payment continues to be a major issue for the construction industry.
11.65The Murray Review considered that identifying an effective security of payment regime, consideration of the issues and stakeholders’ feedback was underpinned by the following three policy considerations:
Preserving the cash flow of the party that has carried out construction work or provided related goods and services by enshrining its right to receive prompt payment of progress claims.
Providing an adjudication process that ensures disputed payment claims are quickly and efficiently determined so that prompt payment can be made.
Protecting payments made in respect of a progress claim so that the party who receives the payment holds the payment for those to whom it is rightfully due.
11.66The Murray Review concluded that a national approach was required and that to implement the third policy consideration on protecting payments, a cascading statutory trust system should be implemented:
…the overwhelming majority of construction work and materials is carried out and/or supplied by subcontractors, many of whom operate as small businesses. It is therefore incongruous that so little protection is given to secure payments to these contractors who operate at the base of the contractual chain. Moneys paid to a head contractor represent payment not only for its project management but also for the construction work and construction materials carried out and supplied by subcontractors. Such payments should be passed promptly down the contractual chain and not used by the head contractor for its own purposes. Similarly, payments made by a head contractor to a subcontractor should also be passed down to the sub-subcontractors engaged by the subcontractor, and so on down the contractual chain. The Review concluded that the most effective way that payments can be secured from misuse and the risk of head contractor insolvency is by implementing a cascading statutory trust. Only such a statutory trust would secure the payments of all subcontractors, including the most vulnerable at the base of the contractual chain.
11.67The Murray Review recommended the Australian Government take a lead role in establishing a nationally consistent approach using a deemed statutory trust model for all parts of the contractual payment chain for construction projects over $1 million based on the model recommended by the 2012 NSW Collins inquiry. Recommendation 81 of the Murray Review set out how the cascading trust system could work:
The legislation should provide that all cash retentions are to be held on trust:
a)In the case of a principal, the cash retentions should be held on trust for the head contractor.
b)In the case of a head contractor, cash retentions should be held on trust for the subcontractors.
c)In the case of a subcontractor, the cash retentions should be held on trust for the sub-subcontractor.
11.68The DEWR website indicates that the Australian Government is working with the states and territories through the Building Ministers' Forum to consider and respond to the findings and recommendations of the Murray Review. It has been reported in the media that:
The Government intends to consider and respond to the Murray Review recommendations within the current term of Government following a deal with Senator David Pocock.
Funding allocated to the National Construction Industry Forum may be used to progress the security of payments consultation.
11.69The Construction, Forestry, Maritime, Mining and Energy Union (CFMMEU) strongly supported the government taking action to implement the Murray Review recommendations on statutory trusts and explained the need for such a mechanism:
The problem is that cashflow is often relied on by the head contractor as working capital. In other cases, it's more sinister than that. Money is diverted to other projects where they are doing their own developments. It's used to pay debts on projects that have gone bad previously. In some cases, it's phoenixed off into shelf companies, for the purposes of making sure that they don't have to pay people that have actually done work.
The problem is that the people who have actually done the physical work of erecting the buildings, the workers and their employers, which are largely subcontractors, don't get paid. Possession, in this industry, is nine-tenths of the law. That is where we see head contractors unreasonably holding progress payments, holding retentions, and disbursing them outside of the project. We think that the case has been well made that there should be a system of cascading statutory trusts to protect the progress payments and the retention payments of subcontractors in the industry.
11.70The National Electrical and Communications Association supported the urgent implementation of the Murray Review recommendations, suggesting that the government:
Remove the confusion and inconsistency between current laws by enacting a single framework for security of payment that will apply consistency across Australia.
Prepare the draft legislation for consultation with industry and other stakeholders.
Ensure that the draft legislation reflects the recommendations in the Murray Report including provision for cascading statutory trusts in favour of subcontractors and sub-sub-contractors.
11.71The CFMMEU addressed concerns about the administrative costs of the proposed cascading trusts, drawing attention to the findings of the Murray Review:
The fundamental point that needs to be underscored is that the concept of a deemed statutory trust is the only proposal that will provide a cost-effective and fair means of dealing with a party’s entitlement to be paid. Insofar as industry participants reject the concept of a deemed statutory trust because of increased administrative burden, then the evidence from the various previous inquiries that had considered this very issue, suggests otherwise. Both the WA Law Reform Commission and the Collins Inquiry specifically addressed the issue of administrative burden and concluded that this would not be the case. Similarly, in his Final Report, Commissioner Cole expressed the view that the arguments that opponents to a deemed statutory trust had advanced in relation to the increased administrative burden were ‘overstated’.
11.72The CFMMEU also drew attention to the Australian Small Business and Family Enterprise Ombudsman (ASBFEO) working paper in 2018 on cascading deemed statutory trusts in the construction sector. The ASBFEO found that for medium businesses (20employees), the cost is small at 0.1 per cent of annual revenue. The costs are moderate for businesses with 2–10 employees at around 2 per cent of annual revenue but are higher for a sole operator at 3.5 to 4 per cent of annual revenue. Based on those findings, the ASBFEO recommended that:
Statutory trusts be implemented to protect payments to subcontractors in the event of their contractor’s insolvency and to decrease payment times.
While we support cascading deemed statutory trusts for commercial projects with a value of at least $1million, consideration should be given to a higher project value to avoid capture of the private residential housing sector.
Imposing statutory trusts on very small business is not warranted given their limited resources. We recommend setting a floor to exclude low value sub-contracts within a project. Consideration should be given to a floor value between $100,000 to $200,000 to exclude small business operators.
Franchising insolvency issues
11.73Franchising is a significant business architecture in Australia with an estimated market size of $172 billion per annum. There are approximately 1,200 different franchise systems, over 800,000 franchised businesses and the sector employs more than 500,000 people. Franchisees are the operators of individual franchise business, while franchisors establishing the franchise business model and are the owners of the franchise system. Franchise arrangements are regulated by the Australian Competition and Consumer Commission (ACCC) under the Franchising Coded of Conduct.
11.74Franchisees can be dependent on the franchisor’s good faith and competent business operation and may therefore face significant issues if a franchisor becomes insolvent. Professor Jenny Buch noted that:
Franchisees invest significant sunk costs in their business, which cannot currently be recovered from an insolvent franchisor. The franchisees do not see the insolvency coming in the same way as unpaid employees or late-paid trade creditors may do. They can rarely take proactive action to protect their rights and assets.
11.75Specific issues that arise for franchisee when the franchisor becomes insolvent include:
Franchisees do not get the same voice as franchisor employees and creditors during a liquidation;
being unable to use intellectual property licences that are essentially to the operation of the individual franchises;
franchisor control or involvement in leases for premises;
lenders taking security of franchisor's and franchisee's assets need to operate franchises;
when liquidators are winding up a franchisor, a franchisee may face many uncertainties relating to leases, franchise agreements, supplier contracts, marketing funds and IP licences; and
liquidators can disclaim onerous contracts.
11.76Professor Buchan made the following suggestions for reform to address some of the above issues:
requiring franchise marketing funds to be held in trust;
entrenching ipso facto right for franchisees, so that they can leave the franchise brand and trade independently;
expand directors’ duties in a franchise network to duties towards franchisees;
recognise and eliminate unjust enrichment of franchisors creditors;
where franchisors sell franchises while insolvent, make defrauded franchisees priority creditors;
allow franchisee representation at creditors meetings;
require liquidators to select competent buyers of the franchise chain, not simply anyone who can satisfy some of the franchisor’s creditors demands; and
expand the FEG to include the employees of franchisees of insolvent franchisors.
Committee view
Fair Entitlements Guarantee
11.77The committee is concerned about the potential for other companies to pursue novel uses of schemes of arrangement to undertake a restructuring, such as that in the Ovato Group, which exposed shortcomings in the legal framework design to prevent misuse of the FEG. The committee suggests that the government should develop reforms to improve the framework designed to prevent the misuse of the FEG by such schemes of arrangement. The committee considers that areas suggested for reform by DEWR are a good starting point.
11.78The committee notes evidence from ASIC that it has not detected any further attempts to use such approaches. Hence, the committee suggests that it is open to the government to address such issues through the proposed comprehensive review or, if it becomes apparent that the need for reform is more urgent, then to pursue such reforms separately from the proposed comprehensive review.
11.79The committee recommends that the government develop reforms to improve the framework designed to ensure the policy objective of access to the Fair Entitlements Guarantee as a scheme of last resort, both to prevent misuse by novel schemes of arrangement, phoenixing, and other practices and to ensure capture of all individuals with valid entitlements.
Independent employee-like contractors
11.80The committee notes that before the 2022 Federal election, the then government committed to empowering the Fair Work Commission to inquire into and set minimum standards in ‘employee-like work’, such as independent contracting in the gig economy. The committee further notes that the government is currently considering reform options and consulting stakeholders on how to implement this commitment.
11.81The committee welcomes the proposed reforms and encourages the government to consider the impact of insolvency on independent employee-like contractors.
11.82The committee notes the potential of worker entitlement funds to protect employees' entitlements if the employer becomes insolvent. Worker entitlement funds can be complementary to the FEG in that they can deploy support more quickly and cover some of the gaps between the FEG coverage of entitlements and the actual entitlements owed.
11.83The committee considered with interest Incolink's proposed reforms to make legislative changes to fair work and fringe benefits legislation to enable employers to make annual leave contributions to worker entitlement funds, in addition to the existing categories of entitlement, which are employee long service leave, sick leave or redundancy payments. The committee has not had the opportunity to examine the benefits and costs of such a proposal. Views diverged amongst committee members as to the need for further consideration of this matter. Some consider it to be worthy of such, but note that as the proposal has a broader focus than insolvency, it may be more appropriately considered in a standalone consultation process (as opposed to part of the proposed comprehensive review of insolvency). Other committee members have significant concerns with these kinds of arrangements.
Security of payment reforms
11.84The committee notes the Murray inquiry recommendations that the Australian Government take a lead role in establishing a nationally consistent approach using a deemed statutory trust model to all parts of the contractual payment chain for construction projects over $1 million. The committee further notes that the Australian Government is working with the states and territories through the Building Ministers' Forum to consider and respond to the findings and recommendations of the Murray Review.
11.85Evidence put to this inquiry supports the proposed cascading trust approach. Hence, the committee supports the government continuing to pursue the Murray Review reforms.
Franchising insolvency issues
11.86The committee notes the significant issues that franchisees face over and above other creditors when franchisors become insolvent. The committee is grateful for the suggestions for reform put forward by Professor Buchan. Unfortunately, the committee has not had the opportunity to seek further evidence from other submitters and witnesses of franchising insolvency issues. Therefore, the committee is not able to make formal recommendations. However, the committee does consider that the issue and suggestions raised are worthy of further consideration by the comprehensive review or the government.
11.87The committee recommends that the comprehensive review consider and report on franchising insolvency issues.