If a business runs into financial issues, there are different strategies that work to suit the circumstances. Profitability and cashflow improvements may do, or a turnaround and restructuring engagement may be required to keep you on track, while in other cases you may have not options besides a corporate liquidation.
If liquidation is unavoidable, one strategy that company directors may employ is selling their existing business and/or assets. While this could be to a competitor or unrelated organisation, this can be difficult to achieve and directors may decide that the best option to save the business is to sell it to a new company of which they are director – also called a sale of business to a related party. However, this should not be done to deliberately avoid paying debts and there are many key considerations that you have to take on board.
What is a related party?
When a company sells its business and/or assets to pay off creditors or restructure its finances, they can be purchased by a related party. Due to the director's knowledge of the assets and business, these parties will usually purchase the business and/or its assets at a higher price than an unrelated party – especially in the case of SMEs. Any or all of the following could be sold to the new company:
- Plant and equipment and motor vehicles,
- Real estate,
- Intellectual property,
- Customer lists,
- Finance agreements and leases, and
- Employees and entitlements.
This purchase can happen before or after the appointment of a liquidator, and can also occur in conjunction with an administrator, or as part of a deed of company arrangement (DOCA) process. While separate from an official turnaround and restructuring, it is a similar process through a formal insolvency appointment. It is worth considering what impact the appointment of an insolvency practitioner may have on your business. They often will not, or cannot (eg. building companies), trade the business on.
The crux of selling to a related party is the owner of a business facing financial struggles can sell off the company at a better price than to another body. Done properly, this can provide funds to provide a better return to creditors in the original company.
Anyone that pays attention to business news will, however, notice that the term 'phoenix activity' is often applied to the sale of a business or assets to a related party. Importantly, phoenix activity can be classed as "illegal" – which is the next clarification it is crucial to understand.
Staying on the right side of the law
Legal issues can arise with the sale of a business to a related party, which is something the ATO and Australian Securities and Investments Commission (ASIC) are very wary of. The illegality occurs when measures are taken to avoid paying off the debts of the initial company, or when assets are not purchased at fair value. Illegal phoenix activity can results in the directors being liable for damage caused to their company. They, and their advisors, may face criminal prosecution and a legal claim may be made against the related purchaser if it has not paid fair value for the business and assets it received.
For example, a business owner may find themselves in the corporate insolvency process. They then start up a new company with themselves as director, and then purchase all of the assets from their old organisation at little or no purchase price, or not paying the purchase price as they are in charge of both sides of the transaction.
"Genuine company failure and liquidation… is a legitimate use of the corporate form"
This may allow the business to escape the brunt of a corporate insolvency that befalls the first company, or to prevent the seizure of these goods by the ATO or creditors. However, ASIC and the ATO are clamping down on this severely, as it is illegal and causing serious loss to the ATO and other businesses.
'Genuine company failure and liquidation (where a director responsibly manages a company and its business subsequently continues after liquidation using another company), is a legitimate use of the corporate form,' advises ASIC.
The benefits of selling to a related party
For many businesses, especially small to medium enterprises, the cost of voluntary administration can be prohibitively expensive and cause terminal damage to a business and its reputation. Voluntary administration is a debt management method that is simply better suited to companies with large scale debts and turnover in the millions of dollars.
"Legal phoenixing is also beneficial to society at large because it encourages entrepreneurism"
Selling on your company's business may therefore provide the only affordable way for the business to survive. It can also enable employees to keep their jobs, which would generally be lost through the corporate liquidation process. On top of this, you can retain crucial assets for continuing to operate in your industry.
A Melbourne Law School dissection of this also states that "legal phoenixing is also beneficial to society at large because it encourages entrepreneurism". It provides better outcomes for the directors, potentially employees, and can foster better general business conditions. For this reason, systems focussed on rescuing businesses are used in the US and the UK.
Is it the right move for your business?
While there are clear benefits to legally undertaking a sale to a related party, it may not necessarily be the right move for your business. Such a delicate process depends entirely on your company's situation, the viability of its business, the value of the assets and the ability of the new company to pay the purchase price for the assets (debtor finance (LINK to article) is often used here). .
It is a situation that requires accurate and professional financial advice, to ensure your next steps can be undertaken safely, to minimise the risk of you breaching your director's duties and the related company being sued. The professionals at Cactus Consulting specialise in pre-insolvency advice and helping business owners to understand their financial situation, as well as how to get out of it. Get in touch with our team to find out if selling to a related party is the right move for you.