5. Problem Identification
5.1 Definition of Phoenix Companies
A phoenix company is a company that has been "reborn" soon after (and in some cases before) its failure. The new company takes on the failed company's business, often using a similar name, the same managers and directors, and the same assets. The use of phoenix arrangements to sell the business as a going concern is an alternative to breaking-up and selling the business assets individually.
5.2 Where Phoenix Companies Serve the Public Interest
It is clear that the use of phoenix arrangements is counter to stakeholders' interests in only a subset of cases. Many phoenix situations will, in fact, promote the interests of creditors (including employees) through lower transaction costs and a higher sale price than would occur without phoenix companies. The business fetches a higher price through it being sold as a going concern than if its assets were broken up and sold individually. A higher price will be received, for example, where the existing managers and directors increase the company's sale value, or where sale to the managers will realise the highest price, for example. The value of phoenix arrangements is particularly pronounced where the business generates a large income stream yet has relatively few assets, for example, a computer consultancy business.
Phoenix arrangements may also result in companies avoiding insolvency and its associated costs. For example, rather than liquidating an insolvent company, creditors may prefer to have their security interests transferred across to the new company at a discounted value, but without first imposing formal insolvency proceedings.
In essence, provided the vendor is receiving true market for the sale of the company's assets (the highest price purchasers would be willing to pay for those assets), the Ministry considers that the use of phoenix companies is an effective way to meet creditors and debtors' collective interests. Employees, in particular, may benefit from the continuing employment opportunities provided by the continuation of the profitable business of an otherwise insolvent company. Similarly, through the entity continuing intact, trade creditors are more likely to benefit by retaining their supplier relationship with that entity.
5.3 Where Phoenix Companies Are Counter to the Public Interest
The owners/directors of a failing company may seek to sell that company (or part of that company) as a going concern, but leave it owned and/or managed by the same people in a deliberate effort to frustrate creditors' legitimate interests. This would occur where the business is transferred at less than market value before insolvency, thereby reducing the funds available to creditors. To do this, directors would need to obtain valuations made on a basis that suits the directors' interests rather than reflecting the market value of the business.
Besides disadvantaging creditors, use of phoenix companies in this way would allow directors who mismanaged the original company to retain control of the business to their benefit but to the detriment of the new company and other businesses that deal with that company.
Depending on the prevalence of the problem, the inappropriate use of phoenix companies could lead to less confidence in the value of creditor security, and the use of measures to counter risk to that security (for example, insurance such as income protection for employees, and increased monitoring of debtor behaviour). This in turn could lead to higher transaction costs and an increased cost and reduced availability of credit. There are also redistribution consequences, that is, assets being transferred from creditors to the owners/managers/directors of the failed company.
The Ministry considers the problem is most likely to arise before liquidation, when the company is still in the hands of its directors. In liquidation, the company and any asset sales are the responsibility of the liquidator/receiver, who is required to act in the interests of creditors by securing as high a price as possible for the company's assets in the circumstances.
The Ministry does not consider the interests of secured and unsecured creditors to diverge sufficiently in liquidation to make it likely that secured creditors would operate a phoenix arrangement to the disadvantage of unsecured creditors. In fact, the opposite (a preference for realising the assets individually) appears likely to be the case.
Even where company assets are expected to realise a higher price as a going concern, secured creditors can be expected to prefer breaking up and selling the company assets if the prices received meet, or nearly meet, the secured creditors' debts. This is because secured creditors will not wish to continue to operate the business as a going concern (in readiness for sale) in these circumstances (even though it would be in the unsecured creditors' interests). To do so would risk further deterioration of the value of the company's assets, threatening secured creditor security. Some favour voluntary administration as a mechanism for overcoming this problem, and it will be addressed in that part of the Ministry's review considering voluntary administration.
5.4 Phoenix Companies: An Issue of Perception
The use of phoenix arrangements during company insolvency tends to generate "bad press". Creditors, in particular, may consider it unjust that the directors and managers who presided over the failed company, the insolvency of which cost them the value of their interests in that company, retain their positions, apparently unaffected by the insolvency. This "bad feeling" towards the managers and directors may occur even where the phoenix arrangement is beneficial to creditors' collective interests.
Further, especially where the creditors who lose out are employees or small unsecured creditors, there may be a perception that secured creditors have benefited at their expense in any phoenix company arrangement. Again, this may be the case even where the phoenix arrangement increased, or at least did not reduce, the payout to those creditors.
Although creditor perceptions are important and should be acknowledged, ultimately the collective interests of the many stakeholders in the insolvency regime need to take precedence in the development of government policy in this area.
5.5 Legislative Provisions to Prevent the Abuse of Phoenix Companies
Several legislative provisions in the Companies Act 1993 militate against directors and mangers using phoenix companies to defeat creditors' legitimate interests of creditors. The main provisions, with a very brief description, are identified below.
5.5.1 Voidable Transactions
5.5.1.1 Section 297: Transactions at Undervalue
Section 297 provides, among other things, that a liquidator may recover from any other party to the transaction any amount by which the value of the consideration or benefit the company provided exceeded the value of the consideration it received.
5.5.1.2 Section 298: Transactions for Inadequate or Excessive Consideration with Directors and Certain Other Persons
Section 298 provides for the liquidator to recover from the person, relative, company or related company any amount by which the value of the business (including goodwill) exceeded the value of any consideration the company received.
5.5.2 Directors' Duties
Section 131: Duty of directors to act in good faith and in best interests of company
Section 133: Powers to be exercised for proper purpose
Section 134: Directors to comply with Act and constitution
Section 135: Reckless trading
These sections require that a director of a company, when exercising powers or performing duties, must act:
- In good faith and in what the director believes to be in the best interests of the company;
- For proper purpose;
- In compliance with the Companies Act and the constitution of the company; and
- In a manner that is unlikely to create risk of serious loss to the company's creditors.
5.5.3 Repayment of Money or Property
Section 301: Power of court to require persons to repay money or return property
Section 301 allows the court to order a person (including past or present directors or managers) to restore money or property, or contribute compensation where that person has been guilty of breach of duty or trust in relation to the company.
5.5.4 Director Prohibitions
Section 385: Registrar may prohibit persons from managing companies
Section 385 allows the Registrar to prohibit, for up to five years, a person from being a director or promoter, or participating in the management, of a company. The Registrar can do this where that person was wholly or partly responsible for a company being put into liquidation.
5.5.5 Pooling of Assets
Section 271: Pooling of assets of related companies
Section 271 allows a court to order that a company that is or has been related to a company in liquidation must pay to the liquidator the whole or part of any or all claims made in the liquidation.
5.5.6 Offences
Section 380: Carrying on business fraudulently
Section 380 (b)(ii) provides that an offence is committed when a director, with intent to defraud creditors, causes property to be given or transferred to any person.
Principally, the Companies Act requires that the "rebirth" of a company's business into another entity must be undertaken at market value. That is, creditors in the insolvent entity must not be disadvantaged, through a lower price received for the business, as a consequence of that business being sold as a going concern.
5.5.7 Other Legislation
In addition to the Companies Act, section 234 of the Employment Relations Act 2000 provides a mechanism whereby officers, directors or agents of an insolvent company can be held personally liable for unpaid minimum wages and holiday pay if they have directed or authorised the default in payment of these monies to the employees.
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