Professional Service Provider in Phoenix Activity

Advisors be Aware!!

The Australian Securities and Investments Commission (“ASIC”) has recently taken action against a Sydney Lawyer for his “involvement” in phoenix activities by the directors of eight (8) companies.

Phoenix activity is considered by the ASIC to be where a director acts in a manner which intentionally transfers assets at a reduced or nominal value to a new entity controlled by that director (or his nominees) and which effectively denies creditors access to those assets to pay the debts of the transferor company.

Phoenix activities in themselves are not illegal pursuant to the various provisions of the Corporations Act, 2001 (“the Act”), however, it is incumbent upon directors pursuant to Sections 180,181, 182 and 183 of the Act to carry out their duties with care and diligence, in good faith, and not use their position for gain or advantage or cause detriment to the corporation. Section 79 of the Act imposes a liability on those “involved in” breaches of the Act.

ASIC commenced proceedings against Mr Tim Somerville¹ resulting from his advice to the directors of eight (8) unrelated companies which led to those companies effectively transferring assets and their businesses into new entities while leaving liabilities to unsecured creditors (including employees) and the Australian Taxation Office (“ATO”) in the old entities.

In each case Mr Somerville provided advice suggesting to the directors that they should incorporate a new entity and transfer the assets of the existing trading entity to the new entity at a nominal value. He also advised the directors to offer employment in the new entity to all existing staff on the same terms and conditions on which they were currently employed but leave their employee entitlements as a liability in the old entity.

The consideration for the transfer of the assets was shares in the new entity such shares being entitled to receive all dividends from profits of the new entity until such time as the consideration for the sale was paid in full.

In the particular matters on which Mr Somerville had given advice the companies have never paid a dividend and therefore effectively no consideration has been paid for the purchase of the business or the assets transferred.

Phoenix activities have been an area examined by ASIC in the past where directors have themselves entered into similar arrangements to those described above, however, this is the first occasion on which ASIC has proceeded to prosecute an advisor for providing the advice to directors.

In the cases examined by ASIC, Mr Somerville had written to the directors informing them that the companies of which they were directors may be subject to action for insolvent trading, were they to continue trading in the current entity. Mr Somerville then suggested the procedures which would be appropriate to create a new entity, transfer the assets of the currently insolvent companies to that entity whilst leaving the outstanding liabilities to unsecured creditors including the Australian Taxation Office and employees for their accrued entitlements in the old entity.

In each case Justice Windeyer AJ held that:

• There was no proper purpose of the phoenix transactions other than to preserve the assets in a new company without the liabilities of the old company;
• In each case the directors used their position to obtain an advantage for themselves and the new company, in preserving the assets, whilst inflicting a detriment on the old company by leaving the liabilities behind;
• In each case the directors acted knowing the old company was insolvent, and acted to prefer their own interests in favour of creditors of the old company.

In each case, the director was disqualified from managing a corporation for a period of two (2) years and the solicitor was disqualified for acting as a director of a corporation for a period of six (6) years. Mr Sommerville was operating via an incorporated legal practice, employing in excess of 50 staff.

It is incumbent upon directors and their advisors to ensure that there is adequate consideration for any sale or transfer of business assets to a new entity and to ensure that the transaction is transparent to any investigation subsequent to the sale or transfer.

The above case reinforces the need for professional service providers to be prudent in their dealings with clients who they consider to be at risk of insolvency.

1 ASIC v Somerville & Others (2009) NSWSC 934