7. Problem Definition
7.1 Origin of the Phoenix Problem
There are two ways the phoenix problem may arise.
7.1.1 Legislative
The first is if the legislation does not adequately protect creditors' interests or creditors from the abuse of phoenix companies. The benefits of reforming the law to better protect creditors would obviously need to outweigh the expected costs. Benefits might include a reduction in uncertainty and transaction costs (in turn resulting in cheaper credit to debtors), while costs could include administration costs (developing policy, enforcement and review), compliance costs and possibly wider regulatory costs.
Anecdotal evidence from the Business and Registries Branch of the Ministry of Economic Development and comments by the Law Commission in their discussion document, Priority Debts in the Distribution of Insolvent Estates, suggest gaps in the companies legislation are not the primary contributor to the phoenix company problem. The Law Commission, in addressing recent recommendations in Victoria on phoenix companies, comments that:
"New Zealand law is generally adequate in this area, with disqualification provisions having improved significantly with the passing of the Companies Act 1993. In addition, the laws in New Zealand relating to directors' duties provide adequate remedies against directors when phoenix companies are used in bad faith to defeat the claims of creditors."
In fact, it is notable that Victoria identified some provisions in New Zealand legislation as offering potential solutions to the phoenix problem, for example, the Corporations (Investigations and Management) Act 1989.
7.1.2 Enforcement
The second way phoenix companies may frustrate insolvency objectives is where laws do protect the interests of creditors, but it is not practical to effectively enforce those laws.
Currently, effective enforcement relies on the private actions of creditors and civil remedies. It may be the case that effective enforcement is frustrated by:
- The free rider problem: that is, creditors may have insufficient incentive, by themselves, to take court action against the debtor even though collectively it may be in their interests to do so. Excessive transaction costs may prohibit co-ordinating collective action, together with the perception that court action will not be successful. In particular, the latter can be problematic due to the difficulty for creditors and liquidators in establishing the market value of the business sold. There is no observable market value outside the actual transaction.
- The high cost of accessing the court system and the cost of the subsequent investigation. Again, any decision to pursue court action must be weighed against the cost of taking that action, the probability that the action will be successful, and the expected return to creditors if it is. The higher the cost of accessing legal remedies, the less likely it is creditors will undertake enforcement action.
- Insufficient penalties to deter inappropriate debtor action. For example, the unwinding of voidable transactions does not include a provision for a penalty above the difference between the transfer price and fair value. This is likely to provide minimal, if any, deterrence effect.
The obstacles identified above are compounded where the amounts outstanding to creditors are small (expected benefits are small) or where the company structure is complicated and there are a large number of creditors (the free rider problem, and the high cost of co-ordinating court action).
The Ministry considers the principle contributor to the phoenix problem is a lack of effective enforcement.
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