The Legalities of a Failed Business

Business StrategySo, you have received a letter stating that one of your creditors has entered either receivership, liquidation or bankruptcy. We hear these terms all the time, but what do they actually mean and, most importantly, what do they mean for the owners and controllers of those businesses?

When a business is not succeeding it may firstly be placed into receivership. This means that a secured creditor has appointed an external party (the receiver) to administer the assets of the business. Usually, the business will continue to trade as normal whilst the receivership is underway.

The secured creditor will usually hold security over some or all of the assets of the business. The secured creditor will often be a bank or other financial institution.

The primary role of the receiver is to call in and sell as many of those assets as are necessary to repay the debt owed by the business to the secured creditor. Once those assets are sold and the secured creditor is repaid, the receivership will usually end and the business will continue to trade.

The receiver’s first duty is to the secured creditor. Much like a mortgagee who takes possession of and sells real estate following the default of a mortgagor, the receiver must ensure that the property is not sold for less than its market value. If a receiver is appointed to a company, it must report to the Australian Securities and Investments Commission (ASIC) every six months as to the amount of its receipts and payments. Other (unsecured) creditors are able to obtain a copy of those statements from ASIC.

A secured creditor may hold a ‘fixed charge’ over the assets of a business (that is, a charge over fixed assets such as land, buildings, plant and equipment). If those assets are sold, the proceeds of sale of the charged assets must firstly be paid to the secured creditor and any balance will then be paid to the company.

If the secured creditor holds a ‘fixed and floating charge’ (that is, a charge over all of the non-trading assets of the company – real estate, plant and equipment, intellectual property rights, book debts, contractual rights – plus a charge over all cash and stock-in-trade enjoyed by the company from time to time), then the receiver must pay the proceeds of sale in the following order: firstly to priority claims (such as employee entitlements), secondly to the secured creditor and thirdly to the company.

If the process of receivership fails to gain sufficient funds to repay the debt owed to the secured creditor, the business (if a company) will usually then be placed into liquidation. In that case, a liquidator will be appointed to take control of all of the assets of the company and to sell them. The proceeds of sale will then be paid to secured creditors. Anything left over will then be divided between unsecured creditors according to their entitlements. This is the often well-publicised situation in which creditors receive ‘5 cents in the dollar’ or some similarly trifling amount.

Once all funds are paid out, the liquidation will usually come to an end and the company will be wound up. The liquidator’s fees will be paid as a priority, so once those fees and the costs of liquidation are extracted from the sale proceeds, there is often very little left for payment to unsecured creditors.

If, however, the directors of the company are deemed to have allowed the company to trade whilst insolvent (that is, to have incurred debts where the company had no prospect of being able to repay them), they can be held personally liable for those debts. This can mean that the liquidation of the company might not be the end of the matter. Directors can be sued for those debts. The liquidator will only commence court action for insolvent trading with the financial backing of one or more creditors. If the court orders that the directors are indeed liable for those debts, the liquidator will have a number of recovery options available to him, including having the directors declared bankrupt.

Under the Corporations Act, an undischarged bankrupt is automatically disqualified from managing a corporation or being a director or secretary of a company. A breach of this law can lead to fines of up to $5,500 or one-year imprisonment.

If a person who is a sole director of a company becomes bankrupt, the company will be wound up, irrespective of whether or not it has first been placed into liquidation.

Of course, the best thing for any business to do is to ensure that its financial position is such that the closest that it will ever come to receivership, liquidation or bankruptcy is to read about them on the pages of this magazine.