Understanding Legal And Illegal Phoenix Activity In Australia

Definition and types of phoenix activity

Question:

Disuses About The Previously Wound Up Or Liquidated Company?

Theoretically, phoenix activity stems from the idea of a new organisation ‘rising from the ashes’ of a previously wound up or liquidated company; the new company maintains the same nature of business and controllers (Anderson, O'Connell, Welsh, & Withers, 2014). Phoenix activity can be legal or illegal; where an organisation fails but on resurrection maintains its worth, employee entitlements and other financial obligations to creditors then this is considered as legal Phoenix activity. However, engaging in calculated, and at times predictably repeated, liquidation in order to evade tax and other financial obligations is considered illegal phoenix activity (Fair Work Ombudsman, 2012). As such, whereas not all Phoenix companies are fraudulent, those formed with the intent to deceive employees and creditors are categorised as fraudulent and as such engage in illegal phoenix activity (Margret & Peck, 2015).

Phoenix activity can be socially beneficial where a company is able to genuinely reinvent itself after failure. The benefit arises from the maintenance of employment, and services which in themselves contribute to the general economic growth of the society. Further, phoenix activity, also known as ‘phoenixing’, allows for efficiency in that the large transactions costs that would accompany an insolvency process are mitigated as a business’ core structure; customers, employees, suppliers and assets, are maintained (Roach, 2010). However, where the element of deceit to evade taxes and other financial obligations comes into play; Phoenix activity becomes a costly socio economic affair. Fair Work Australia in a recent report estimates that illegal phoenix activity costs the economy well over three billion dollars annually (ASIC, 2013).

With regard to purpose, there is a dearth of literature exploring the underlying motivations of phoenix activity; it may be driven by the desire to protect a particular class of stakeholders, the desire to gain competitive advantage or the need to survive (Matthew, 2015). Legitimate Phoenix activity serves to allow for the continuity of responsibly managed organisations after experiencing genuine business failure. On the other, illegal phoenix activity merely serves as a means of generating personal wealth or creating an unfair competitive advantage for fraudulent directors and business controllers (Australian Government, 2009).

Phoenix activity affects various stakeholders within the industry. It affects the directors, shareholders, the business community or industry in question, employees, creditors, suppliers or contractors, the government and the economy at large (ATO, 2017). Directors who engage in phoenix activity benefit by way of gaining a competitive advantage over other organisations within the same industry, this is a creation of wealth.

Social and economic impact of phoenix activity

However, employees and creditors are likely to lose the most where Phoenix activity occurs; employees can lose employment, wages as well as other benefits such as superannuation which may have accrued prior to liquidation of the company. Creditors, on the other hand, are likely to be left with a company that lacks assets which can be used to recover what is owed to them. Additionally, governments lose a source of revenue with which to drive development in the community by way of service delivery; that is, construction and maintenance of hospitals, roads, education facilities among others.

Further, as previously mentioned, phoenix activity is costly to the Australian economy. Reports estimate approximately three billion is lost through Phoenix activity annually; this is by way of tax evasion as well as lost wages which contribute to a loss of revenue (ASIC, 2013).  Evidently, legitimate Phoenix activity is of great benefit as it allows an organisation the opportunity to reinvent itself and contribute to economic growth. However, where dishonesty and deceit come to play, only the fraudulent player's benefit and the larger society stands to lose significantly.

Australian legislation, that is the Corporations Act 2001 (Cth), fails to expressly define or prohibit for Phoenix activity (Harley, 2014). The Corporations Act 2001 lacks specific provisions that would make Phoenix activity illegal. However, the Act highlights directors duties under ss 180-183 breach of which would accounting to illegal phoenix activity.

As aforementioned, whereas the Corporations Act 2001 (Cth) lacks specific provisions with regard to illegal phoenix activity, breach of various duties covered by the act by company directors would amount to fraudulent phoenix activity and as such elicit legal penalties. These obligations are provided for under ss 180-184 of the Act; additionally, the Act accords the Australian Securities & Investments Commission (ASIC) power to liquidate abandoned companies as a precautionary measure to illegal phoenix activity.

With this in mind, Phoenix activity may lead to a breach of the directors’ duty of care and diligence as provided for under s 180 of the Act 2001 (Cth). This is a civil obligation that requires company directors to exercise a reasonable degree of care and diligence while executing their company duties. In this regard, any decision made on matters relevant to company operations must be taken in good faith and for a proper purpose; that is, they should be in the best interest of the organisation and not a materialisation of personal interest.

Stakeholders affected by phoenix activity

Additionally, according to s 184, where directors employ recklessness or intentional dishonesty in the execution of their duties they are in breach of their duty to exercise good faith and stand liable for a criminal offence. Using their position dishonestly with the objective of gaining personal interest amounts to a breach of duty; as previously stated, dishonesty and self-interest are distinctive features of illegal phoenix activity. 

Various cases in Australian law provide examples of phoenix activity; Australian Securities & Investment Commission (ASIC) v Somerville & Ors [2009] NSWSC is one such recent case that has set precedence in this legal area. The issue in question was whether t directors and a solicitor, Mr Somerville, were in breach of statutory obligations and liable for asset stripping or Phoenix activity after engaging in the restructuring of several businesses that were experiencing financial challenges.

Mr Somerville had advised several company directors to restructure their failing companies by forming a new company and selling the old company’s assets to the new one. The terms of restructuring included a transfer of assets, essential property, plant and equipment, termination and re-employment of staff and issue of new shares. However, outstanding liabilities were left under the old company; as such any creditors would lack assets to lay claim of what was owed to them. As such, the directors were able to preserve company assets without previous company liabilities.

The Court, in its determination, found the directors in breach of their statutory obligations outlined under ss 181-183 of the Corporations Act 2001 (NSW). The Court was also convinced that Mr Somerville, as an advisor, had aided the directors in the breaches mentioned above. The directors, with the aid of their solicitor, had engaged in phoenix activity, business known as asset stripping which amounted to breach of duty.

Three things reign true with regard to Phoenix activity; firstly there is no acclaimed definition, legislation does not provide an express offence and finally, restructuring businesses after failure is a recognised and accepted business activity in so far as statutory obligations are observed (Anderson, 2015). In as much as there is no specific prohibition or offence, there is an array of provisions in legislation that aim to combat improper conduct by company directors that would lead to phoenix activity. These can be found in the Corporations Act 2001 (Cth) as well as the Taxation Administration Act which provide penalty as well as disqualification provisions for directors (Anderson, Hedges, Ramsay, & Welsh, 2017). A significant amount of scholars believe that regulators are well equipped with the current provisions to combat phoenix activity. However, the estimated cost of phoenix activity to the Australian economy, as aforementioned, intimates that this activity is still prevalent and much remains to be done.

Legislation surrounding phoenix activity in Australia

Proponents believe that an express Phoenix offence would transmit an educative message to directors and advisors in company matters thus increasing commitment to compliance with duties (Anderson, Hedges, Ramsay, & Welsh, 2017). Compliance with the law is driven by three factors which could either be normative, calculated or social. Where one relies on their internalized values or moral reasoning to comply with the law, they are said to be normatively motivated to comply. Compliance, in this case, is influenced by social perceptions towards the behaviour in question. As such, express prohibition of a certain activity increases its perception as immoral and thus motivates compliance. In the same regard, social as well as calculated factors also support the proposal to adopt a Phoenix prohibition. Based on this ideology, scholars argue that a Phoenix prohibition or offence is likely to be more successful as a deterrent over current legislative provisions.

Additionally, the lack of a specific offence plays a role in the existing loopholes and inconsistencies in available data on phoenix activity. Without a specific definition and a specific offence, researchers cannot conclusively quantify the incidence, enforcement or cost of fraudulent phoenix activity (Keating, 2015). The current data paints a dim picture of Australian Phoenix activity, thousands of companies are estimated to engage in illegal phoenix activity annually, however, conclusive figures cannot be drawn as there is no express criteria against which to test company activities. In this regard, it is evident that a specific Phoenix activity offence or prohibition could aid in conclusively defining and identifying the vice and as such make efforts in combating it more efficient and effective.

However, various challenges lie in the creation of a Phoenix offence or prohibition. Firstly is the risk of penalising legitimate phoenix activity. This is because; creating a prohibition would require outlining a comprehensive definition for phoenix activity. The challenge here lies in the fact that scholars believe that no definition can fully encompass all the elements and characteristics of illegal or fraudulent phoenix activity (Anderson, Ramsay, Welsh, & Hedges, 2017). This is evinced in the current array of definitions available for the term which, though comprehensive in their own right, are faced with various shortcomings. A broad description would likely risk encompassing legitimate activity while a specific definition would risk leaving out various aspects allowing for avoidance through the underlying loopholes in enforcement.

Additionally, attempts to create Phoenix liability through legislation that focuses on the aspect of ‘similar names’ has also proved limiting. The underlying objective in this regard would be to hold directors accountable for financial obligations owed by a company with similar name pre liquidation (Anderson, Ramsay, Welsh, & Hedges, 2017). However, this approach also falls victim to various shortcomings in that, where a new name is adopted the approach would be inapplicable. Legislation in this area could easily encompass legitimate restructuring and could also easily be avoided by directors who intend to adopt Phoenix activity for fraudulent gain.

Obligations of company directors to avoid fraudulent phoenix activity

The discourse above prevents a compelling case both for and against Phoenix activity prohibition by way of legislation. Stakeholders would experience positive and negative consequences alike should a specific provision be adopted. However, it is evident that the negative impact of creating an offence or prohibition outweigh the positive arguments outlined above. This is because setting out specific legislation puts directors who adopt Phoenix activity for the legitimate restructuring of their organisation at risk of facing penalties and subsequently creates loopholes for deliberate perpetrators to exploit. As such, guided by research, it is evident that creating a specific prohibition or offence for Phoenix activity would be more harmful than successful.

In the event that a Phoenix offence or prohibition is adopted, the provision must satisfy various criteria in order to be successful. These criteria collectively aid in the establishment of a structure for a Phoenix offence or prohibition whose enforcement is successful in deterring harmful behaviour. In developing this structure, the research has considered the aforementioned successes and limitations on current legislation affecting phoenix activity. This also includes an analysis of scholarly opinions as to the most effective methods for combating phoenix activity.

Firstly, it is important that the structure of the offence constitutes a comprehensive definition of illegal or fraudulent phoenix activity (Anderson, 2015). The definition provided should be broad enough to encompass all harmful aspects of phoenix activity all while remaining specific to illegal phoenix activity and avoiding or excluding elements of legitimate phoenix activity. As recognised in the discourse above, defining Phoenix activity is crucial to any efforts in monitoring, estimating and combating it. As such, a proper definition will serve as a significant feature of the offence structure and a key contributing factor to the success of the legislation.

The definition mentioned above outlines the prohibited conduct which is a key component of any offence. In addition to this, the prohibition or offence should also consider the element of mental intent; that is the intention. Currently, the concept of intention is outlined in the general duties of directors provided for under the Corporations Act 2001 (Cth). A successful Phoenix offence provision should include intention; studies show that phoenix activity is considered illegal or fraudulent where the intent to deceive is evident. The prohibition or offence should expressly include this element within its structure.

The Phoenix offence structure should also comprise of criteria that allow stakeholders; that is administrators, employees, creditors, regulators among others, to detect Phoenix activity (Anderson, Ramsay, Welsh, & Hedges, 2017). This criterion is derived from the definition set within the offence structure. A recognised set of criteria or elements attributable to Phoenix activity aid stakeholders in monitoring Phoenix activity within their organisation thus serving as a protective or precautionary measure. Additionally, it allows for improved data collection which in essence promotes estimation and analysis of costs and other aspects of phoenix activity.

Case study examples of phoenix activity in Australia

Further, the structure of the offence should comprise of stringent deterrent measures and sanctions for breach of duty that would constitute Phoenix activity. These measures should clearly outline the role and powers of liquidators and administrators during the liquidation process. Available civil penalties should be increased and criminal penalties introduced so as to further deter fraudulent directors from asset stripping. This structure should further include provisions that remove the benefit of phoenix activity to as to further curb the vice.

Additionally, in order to be successful, the Phoenix offence structure must include a detailed enforcement strategy or policy. That is, having outlined the rules and available penalties, the prohibition should highlight how offences will be dealt with and the relevant bodies responsible for monitoring, estimating, determining and prosecuting Phoenix offences. A clear enforcement policy ensures efficiency in the combat against illegal phoenix activity.

In conclusion, the prohibition or offence structure should illuminate the basic elements of any offence; the prohibited activity and the element of intent. Additionally, it should outline elements that would aid stakeholders in identifying phoenix activity; this should begin with a comprehensive definition. Further, the prohibition or offence should also include deterrent measures by way of penalties and finally enforcement policies to ensure its success.

References

Anderson, H. (2015). Phoenix Activity- A Context not a Crime. Australian Insolvency Journal, 35.

Anderson, H., Hedges, J., Ramsay, I., & Welsh, M. (2017). Illegal Phoenix Activity: Is a 'Phoenix Prohibition' the Solution? Corporate Law Teachers Association Annual Conference (pp. 1-26). Melbourne University.

Anderson, H., O'Connell, A., Welsh, M., & Withers, H. (2014). Defining and Profiling Phoenix Activity. Melbourne: Melbourne Law School.

Anderson, H., Ramsay, I., Welsh, M., & Hedges, J. (2017). Phoenix Activity: Recommendations on Detection, Disruption and Enforcement. Melbourne: Melbourne Law School, Monash Business School.

ASIC. (2013, November 4). Small business management-illegal phoenix activity. Retrieved from Australian Securities & Investments Commission: https://asic.gov.au/for-business/your-business/small-business/compliance-for-small-business/small-business-illegal-phoenix-activity/

ATO. (2017, July 25). Illegal Phoenix activity. Retrieved from Australian Tax Office: https://www.ato.gov.au/General/The-fight-against-tax-crime/Our-focus/Illegal-phoenix-activity/

Australian Government. (2009). Action against fraudulent phoenix activity. Commonwealth of Australia.

Fair Work Ombudsman. (2012). Phoenix activity: Sizing the problem and matching solutions. PWC.

Harley, M. (2014, September 14). Australia: Latent defects in Phoenix legislation. Retrieved from Mondaq: https://www.mondaq.com/australia/x/338654/Corporate+Commercial+Law/Latent+defects+in+phoenix+legislation

Keating, E. (2015, October 20). Lack of rules and data about Phoenix activity compounds the problem. Retrieved from Smart Company: https://www.smartcompany.com.au/business-advice/legal/lack-of-rules-and-data-about-phoenix-activity-compounds-the-problem-research/

Margret, J. E., & Peck, G. (2015). Fraud in Financial Statements. London: Routledge.

Matthew, A. (2015). The Conundrum of Phoenix Activity: Is Further Reform Necessary. business Law Teachers Association (CLTA) Conference. Melbourne: Melbourne Law School.

Roach, M. (2010). Combating the Phoenix Phenomenon: An Analysis of International Approaches. eJournal of Tax Research, 90-127.