Restructuring, Professionalism and Ethics in Insolvency Practice

Restructuring, Professionalism and ethics in Insolvency Practice Assessment Item 2 Discuss the legal and professional responsibilities arising from the facts set out below for

1. Gerard Mann, ( a director of Manu Ltd and ManF Pty Ltd) and Reconstruction Remedies
2. Larry Liquidator a registered Insolvency liquidator.

Key facts of the case Manu Ltd (part of a group controlled by Mann family) making parts for specialized medical equipment, in recent years producers of equipment pressuring Manu to lower costs or they will take business elsewhere. In July 2013 Manu Ltd entered contract with one manufacturer to produce parts over 5 years at a set price plus CPI increases. ManF Pty Ltd entered into another production contract for 3 years to produce certain items at a fixed price. To manufacture these products parts machinery came from Germany and both companies incurred substantial debt to the German Manufacturer but hoped that the debt would be paid off out of the contracts. Substantial monies had been paid to the Germans but large amounts are still owed under a time payment arrangement. The machinery failed to perform tasks it was expected to do and the German manufacturers denied any product liability. Further Information required to properly assess the case and advise on the responsibilities of all parties involved. Reconstruction Remedies have closely examined the underlying business of the two companies and believed that the underlying business can be profitable; however none of this information is disclosed in the case notes. The information required can be divided into three categories

1. Financial information required by Larry Liquidator for the purposes of determining solvency of the Manu Group of companies.

• Financial statements of both companies- Profit and loss, Balance Sheet for year ended 30th June 2014.
• Management accounts/cash flow projections for the 2015 financial year.

2. Legal advice in relation to the product liability claim required by the directors of the Manu group of companies and Larry Liquidator

• What legal advice exists in relation to the product liability claim?
• What insurance policies exist that may assist the claim?
• What undertakings were given by Manu to the German manufacturer in terms of the work to be performed by the equipment?
• What director’s guarantees existed in terms of the equipment contracts?

3. Restructuring options information required by the directors of the Manu group of companies and Larry Liquidator

• Does the German manufacturer have a Personal Property Securities Register[1] charge over their equipment?
• What is the ability to restructure the existing debts owed to the German manufacturer?
• What value was RR putting on the old company and new Co? Was fair value consideration being given to the sale of the contracts?
• What independent valuation was obtained to determine the transaction price?

What are the legal and professional responsibilities for Gerard Mann, (a director of Manu Ltd and ManF Pty Ltd) and Reconstruction Remedies? Gerard Mann, (MD for both companies) approached Reconstruction Remedies (RR) in January 2015. RR investigating accountants reports said both companies were underlying profitable. Mr Mann advised RR that given 3D printer developments that manufacturing could be done more cheaply and that the companies were saddled with debt for existing machines and other payment obligations to the German supplier. RR suggested contracts be assigned to “newco”, to be jointly owned by directors of RR and the Mann family. The consideration for purchase of these contracts to be assumption of some of the existing debts in Manu and ManF and the debt owing to the German manufacturer would not be taken over by Newco as well as associated debts in respect of unpaid interest. Discussion to set up Newco and transfer the contracts occurred in Feb 2015. If a turnaround company is one facing immediate challenges to its profitability and thus not meeting the expectations of its shareholders, the Board’s role is to identify and implement a strategy to ensure the success of the turnaround. The Board must assess:

1. the strategy including short and longer term/environmental conditions;

2. the current and prospective implementation or execution of the strategy;
3. the culture of the organisation; and
4. the structure of the organisation.[2]

The Corporations Act specifies for main duties for directors;

• Care and Diligence[3]
• Good faith[4]
• Proper use of position[5]
• Proper use of information[6]

The Act also includes an obligation to prevent a company trading if it has become insolvent[7]. The question is when Manu purchased the manufacturing equipment from the German supplier had they adequately stress tested their projected returns to account for repayment of the loans for the equipment? The Directors of Manu may be able to rely on a defence against insolvent trading if they can prove that when the debt to the German Supplier was incurred that there were reasonable grounds to expect that the company was solvent and would remain solvent even if the debt was incurred.[8] Directors must also consider the interests of creditors where the company is not insolvent but facing insolvency, Walker v Wimborne [9]. Mason J said “ the directors of a company discharging their duty to the company must take into account of the interests of its shareholders and creditors. Any failure by the directors to take into account the interests of the creditors will have adverse consequences on the company as well as for them”[10] Uncommercial transactions[11]. S588FB (1) applies where a company sells property at an amount below market value, it appears from the facts as presented (a formal valuation of the transaction is among the additional information requested) that the transaction may be below market value and this would leave the selling companies with no funds with which to repay the German supplier. Voidable transactions [12] S588FE (2A)(a)(i) states the transaction is voidable if the transaction is an uncommercial transaction for the company, this would be required to be tested. Do the actions of the Director (G Mann) and RR constitute “Phoenix” activity? The concept of Phoenix activity broadly centres on the idea of a second company, often newly incorporated, arising from the ashes of it’s failed predecessor where the second company’s controllers and business are essentially the same. Anderson in “Defining and Profiling Phoenix Activity” [13]describes five types of Phoenix categories, where companies are rescued from corporate failure but the interests of shareholders and creditors may be adversely affected by the restructuring. The first two categories are legal and the other three categories illegal.[14] Anderson categorises the third type of Phoenix rescue as “illegal type 1”.[15] This is where there is a transfer of assets to “Newco” for inadequate consideration and debts are left in the shell of the “Oldco” which is subsequently liquidated. In ASIC v Somerville (2009)[16] the court found that the conduct of directors to be in breach of the duty to consider creditors interests and the directors were disqualified from managing corporations and fined. The court also found that the lawyer who advised the directors was also fined and disqualified from managing companies. However no disciplinary action was ever taken against him, either by the Law Society of New South Wales of Legal Services commissioner.[17] The conduct and actions of RR appear to go beyond the bounds of what is expected when they are engaged by the directors of a failing company. An insolvency Practitioner has a role as an advisor not a director of the company and the actions of RR go beyond that role and take on the role of director[18], agreeing to become shareholders and directors of “newco” would appear to confirm this. For RR’s principals to avoid being classified as Shadow directors they need in their engagement letter set out that they act only as advisors and that they advise management on the turnaround plan but not dictate the terms of the plan. RR, as a firm of advisory Accountants to have a professional obligations to the particular accounting body (and their code of ethics) that the principals belong to ; whether it be CPA Australia (CPA), Institute of Public Accountants (IPA), or Chartered Accountants Australia and New Zealand (CAANZ).[19] It is not disclosed however whether RR is a member of any of these bodies and therefore subject to their codes of ethics. What are the legal and professional responsibilities for Larry Liquidator, a registered Insolvency liquidator? On 12 March 2015 RR appointed Larry Liquidator asking whether he would consent to undertaking a job in respect of both companies. RR often refers work to Larry and in the past year is estimated that around 2% of work undertaken by Larry comes from such referrals. This represents $150,000 in fees. Independence is the key question to be answered when accepting a role as a liquidator or administrator. The appointee must be independent in fact and substance as well as appearance. The Australian Restructuring & Turnaround Association (ARITA) Code of Professional Practice for Insolvency Practitioners Clause 6.6 [20] - Referrals from other Professionals and Creditors sets out where a practitioner must not accept any referral that contains, or is conditional upon:

• The giving or receiving of referral commissions, inducements or benefits;
• the giving or receiving of spotter’s fees;
• the giving or receiving of recurring commissions;
• understandings or requirements that work in the administration will be given to the referrer; or
• any other such arrangements that restrict the proper exercise of the Practitioner’s judgement or duties.

Clause 6.8 [21]sets out the rule that a practitioner may not take on the role if there has been a Professional relationship within the last two years, however if there has been a relationship within the last two years the Practitioner must disclose it in the Declaration of Independence, Relevant relationships and Indemnities (DIRRI) [22] and explain why accepting the appointment will not affect their independence or the perception of independence. There are a number of cases where the independent of a liquidator has been questioned. In ASIC v Edge[23] it was found that the liquidator had breached his duties as a fiduciary in taking an appointment as administrator (and subsequently liquidator) without disclosing a prior relationship with the company’s director. It is however a 2014 decision that has put Insolvency Practitioners on notice that they must consider very carefully how their referral relationships may be seen to affect their independence. In Australian Securities and Investments Commission (ASIC) v Franklin [24] on appeal the court overturned the original decision [25] that the test of perceived independence and impartiality used by the liquidator when accepting the appointment was inadequate and as a result ASIC obtained orders removing the liquidators on the grounds of perceived bias. White J commented “ that in the 2013 financial year that revenue from the Mawson’s group’s referrals (about $250,000) comprises a little over 5% of the revenue of LDD’s insolvency division, and a little over 2% of the firm’s overall revenue.”[26] “ …I do not consider that any fair-minded observer would regard remuneration of the order received by LDD from the Mawson Group’s referrals as modest. Most cerditors of companies such as WCPL and WCQPL are likely to regard amounts such as $250,000 and $500,000 as significant and the hypothetical fair-minded observer is likely to have the same view. At the very least, the fair-minded observer might apprehend that LDD may not wish to put their continued receipt of income in these proportions in jeopardy…..”[27] The Full court applied the “double might” test stated in Ebner[28] The double might test is used by the Court when making a decision in relation to an allegation that a judge is biased. The test is whether a fair-minded lay observermightreasonably apprehend that the judgemightnotbring an impartial mind to his or her duties. The Full Court in ASIC v Franklin suggested that the test may not be applied as rigidly for a liquidator because, unlike Judges, liquidators operate in the commercial world and are required to attract work by developing contacts and relationships.[29] Following the decision of the Court of appeal ARITA has amended Section 6.6.1 of the Code, requiring members to disclose in the DIRRI the name of the referring entity.[30] Larry Liquidator in taking on the appointment as liquidator of the Manu Group of companies may have failed in his duty to be, and to be seen to be, independent, in relation to his previous dealings with RR.[31] Bibliography Cases Australian Securities and Investments Commission v Edge [2007] 211 FLR 137 Australian Securities and Investments Commission v Franklin (Liquidator), in the matter of Walton Constructions Pty Ltd [2014] FCA 68 Australian Securities and Investments Commission v Franklin (Liquidator), in the matter of Walton Constructions Pty Ltd [2014] FCAFC 85 Ebner v Official Trustee in Bankruptcy [2000] HCA 63; (2000) 205 CLR 337 Walker v Wimborne (1976) 137 CLR 1 Legislation Anti-Money Laundering and Counter-terrorism Financing Act 2006 (Cth) Corporations Act 2001 (Cth) Taxation Administration Act 1953 (Cth) Quasi-legislative materials Accounting Professional and Ethical Standards Board, APES 110 Code of Ethics for Professional Accountants, November 2013. Australian Restructuring Insolvency & Turnaround Association, Code of Professional Practice for Insolvency Practitioners, Third Edition, November 2013. Articles/Books/reports Helen Anderson, Ann O’Connell, Ian Ramsay, Michelle Welsh, and Hannah Withers, ‘Defining and Profiling Phoenix activity’, Melbourne Law School, Monash Business School, December 2014 Michael Murray and Jason Harris, ‘Keay’s Insolvency Personal and Corporate Law and Practice’ (Thomson Reuters, 7th Ed, 2011) Fiona Shand. ‘Understanding the Exposures and Liabilities of Directors in a Turnaround Situation’, (Arnold Bloch Leibler, Melbourne, November 2004) Websites/other Australian Financial Security Authority, Personal Property Securities Register <https://www.ppsr.gov.au/ForBusiness/whyregister/Pages/default.aspx> accessed 5th April 2015 Cusoff Cudmore Knox, Referral relationships-when is an Insolvency Practitioner independent? 23rd September 2104 <https://www.ccklawyers.com/journal/2014/9/23/referral-relationships-when-is-an-insolvency-practitioner-in.html> accessed 23 March 2015 Cornwall Stodart, Alert, 23rd July 2014 <https://www.cornwalls.com.au/sharing-knowledge/legal-updates/case-summary-asic-v-franklin-(liquidator),-in-the-matter-of-walton-constructions-pty-ltd-[2014]-fca-85.aspx> accessed 4 April 2015 Cornwall Stodart, Alert, 18th August 2014 <https://www.cornwalls.com.au/sharing-knowledge/legal-updates/changes-to-the-arita-code-in-effect-from-monday,-18-august-2014.aspx > accessed 4 April 2015 1

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[1] Australian Financial Security Authority, Personal Property Securities Register, <https://www.ppsr.gov.au/ForBusiness/whyregister/Pages/default.aspx> accessed 5th April 2015 [2] Fiona Shand, ‘Understanding the Exposures and Liabilities of Directors in a Turnaround Situation’, Arnold Bloch Leibler, November 2004, P15 [3] Corporations Act 2001 (Cth) S180 [4] Ibid S181 [5] Ibid S182 [6] Ibid S183 [7] Ibid S558 [8] Ibid S558H(2) [9] Walker v Wimborne (1976) 137 CLR 1 [10] Ibid CLR 1,7 [11] Corporations Act 2001 (Cth) S588FB [12] Ibid S588FE [13] Anderson, etal , ‘Defining and Profiling Phoenix activity’, Melbourne Law School, Monash Business School, December 2014 P1 [14] Ibid P2 [15] Ibid P16 [16] ASIC v Somerville [2009] NSWSC 934 [17] Anderson, etal ‘Defining and Profiling Phoenix activity ‘, Melbourne Law School, Monash Business School, December 2014 P18 [18] Corporations Act 2001 (Cth) S9 [19] Accounting Professional and Ethical Standards Board, APES 110 Code of Ethics for Professional Accountants, November 2013. [20] Australian Restructuring Insolvency & Turnaround Association, Code of Professional Practice for Insolvency Practitioners, Third Edition, November 2013, Clause 6.6 [21] Ibid clause 6.8 [22] Ibid clause 22 [23] Australian Securities and Investments Commission v Edge [2007] 211 FLR 137 [24] Australian Securities and Investments Commission v Franklin (Liquidator), in the matter of Walton Constructions Pty Ltd [2014] FCAFC 85 [25] Australian Securities and Investments Commission v Franklin (Liquidator), in the matter of Walton Constructions Pty Ltd [2014] FCA 68 [26] Australian Securities and Investments Commission v Franklin (Liquidator), in the matter of Walton Constructions Pty Ltd [2014] FCAFC 85, paragraph 90 [27] Ibid para 95 [28] Ebner v Official Trustee in Bankruptcy [2000] HCA 63; (2000) 205 CLR 337 [29]Cusoff Cudmore Knox, Referral relationships-when is an Insolvency Practitioner independent? 23rd September 2104 < https://www.ccklawyers.com/journal/2014/9/23/referral-relationships-when-is-an-insolvency-practitioner-in.html > [30]Cornwall Stodart, Alert, 18th August 2014 <https://www.cornwalls.com.au/sharing-knowledge/legal-updates/changes-to-the-arita-code-in-effect-from-monday,-18-august-2014.aspx > [31] Australian Restructuring Insolvency & Turnaround Association, Code of Professional Practice for Insolvency Practitioners, Third Edition, November 2013. Clause 6

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