Stopping Phoenix Companies at the Source
Like many other countries, Australia is prey to phoenix company activity. Phoenix company activity involves the incurring (and prolonged non-payment) of business debts through a corporate structure, followed by the transfer of the business (but not the debts) to a new corporate structure.
The result is that creditors of the business are left with no recourse, because their debtor is an insolvent corporate shell. The business is carried on through the new corporate structure, again incurring unpaid debts until it is moved into yet another new corporation (and so ad infinitum).
It is almost impossible to draft laws that can specifically and effectively target deliberate “phoenixing”. This is because modern commercial life is based on the limited liability concept, and it would cripple private sector initiative if personal liability were to be placed on every businessperson who had been involved in a failed company.
In Australia, company and corporate insolvency law is policed by the Australian Securities and Investments Commission (ASIC). Until recently, the main tools it used against phoenixing were:
• providing some financial assistance to liquidators, through the Assetless Administration Fund, to facilitate their investigations into failed companies (but not to fund litigation by liquidators); and
• banning directors who are involved in phoenix company activities. Recently, it has adopted a new tactic, with some degree of success: taking the fight up to professional advisers who facilitate phoenixing.
Mr Somerville was a lawyer. Directors of failing companies would come to him. On his advice, they would establish a new company and transfer their business out of the failing company and into the new one. The transfer of business would be paid for by issuing special shares to the old company (called “V shares”). V shares carried special dividend rights: it appears that they conferred the right to receive all dividends declared by the new company until a specified monetary total was reached.
No dividends were ever paid or declared. Mr Somerville claimed to have given the same advice on “dozens of occasions”. ASIC began proceedings against the directors (for breach of their statutory duties to the old companies) and against Mr Somerville and his company (on the grounds that he was involved in the breaches by the directors).
Sections 181-183 of the Corporations Act provide that a director can be liable for breach of duty if they:
• s181: do not act in good faith the best interests of their company and for a proper purpose;
• s182: improperly use their position to gain an advantage for themselves (or someone else) or to cause detriment to their company; or
• s183: improperly use inside information about the company to gain an advantage for themselves (or someone else) or to cause detriment to their company.
Each of those sections applies, not only to directors, but also to anyone who was “involved” in the relevant contravention. Section 79 says that a person is “involved” in a contravention if the person:
• aided, abetted, counselled or procured the contravention;
• induced the contravention;
• was, by act or omission, knowingly concerned in or party to the contravention; or
• conspired with others to effect the contravention.
Sections 181-183 can be enforced by either ASIC or the liquidator of the company which was the “victim” of the phoenix activity.
What the Court Said
Handing down its decision on ASIC’s application, the court commented that:
It is obvious enough that the real aim of ASIC is directed against Somerville because it is his conduct in advising the other defendants [and] the procedure put in place as a result of that advice, which ASIC wants to see does not happen in the future.
(ASIC v Somerville & Ors  NSWSC 934)
It is also obvious that, as well as targeting Mr Somerville’s operation, ASIC wanted to dissuade other professionals from giving professional advice that might lead to phoenix activity.
For their part, the directors either consented to having declarations made against them or simply didn’t give evidence at the court hearing. As a result, the imposition of disqualification orders on them was almost automatic: each of them was banned from acting as a director for two years:
In each case the director or directors knew that the vendor company was insolvent or reaching insolvency, or ... if a contingent liability became actual then the company would not be able to meet it. ... Thus with the knowledge the vendor company was or was unlikely to be able to satisfy its creditors, the transfers took place to give an advantage to the directors thereby causing detriment to the vendor corporation in circumstances where the interests of creditors fell to be considered.
Mr Somerville was banned from managing corporations for six years (although that was suspended pending an appeal). Importantly, the court rejected Mr Somerville’s argument that he shouldn’t be punished simply for giving legal advice:
That of course may be the position in a normal case, but that depends upon what advice was given. If advice is given the result of which brings about an action by directors in breach of the relevant sections of the Act, in other words, when advice is given by a solicitor to carry out an improper activity and the solicitor does all the work involved in carrying it out apart from signing documents, it seems to me that there can be no question as to liability.
Somerville’s case will provide a strong disincentive to lawyers and accountants who are asked to provide professional assistance to phoenix companies. What is still unclear is the extent to which it is also applicable to other third parties who deal with phoenix companies. The definition of “involvement”, noted above, is very wide and has not been the subject of much judicial consideration. There is, therefore, scope for debate about what sort of activities, other than legal or accounting advice, might constitute “involvement”. This will be a matter of concern to a range of parties, such as credit providers, landlords and other third parties whose cooperation may facilitate the phoenixing of a business.