Some thoughts about the phoenix companies provisions

27 November 2012

Some thoughts about the phoenix companies provisions

Introduction

When they were first introduced in 2007, sections 386A to F of the Companies Act 1993 were heralded as the solution to the problem of phoenix companies. A recent case about the application of the phoenix companies provisions adds to our knowledge about the manner in which they are applied and gives some useful pointers to the way in which the Courts manage what was seen (by some) as a gap in the wording.

To recap, a ‘phoenix company’ is (as the label suggests) a company that rises from ashes of a company failure. There should be no difficulty with the concept of a phoenix company – that does not create the ‘mischief’ described below. Sometimes, there are legitimate reasons for seeking to resurrect the business in a new form that is free of some of the problems that saddled the old one. Such initiatives are in keeping with one of the underlying drivers that are increasingly shaping insolvency laws, being to get the assets of the business back into use as quickly and efficiently as possible. However, this process also has the potential for abuse.

Often, the phoenix used as the vehicle to take on the failed company’s business has the same directors and management and sometimes uses the same name. Again, there may be good reasons for this. The mischief that the phoenix company provisions seek to prevent is the transfer of the business (including the goodwill in the business name) from the failed company to the phoenix at an undervalue and the use of the same or a similar name leading creditors of the phoenix to the belief that they are continuing to deal with the old business.

Personal liability for phoenix directors

The principal weapon in the phoenix company provisions is the risk of personal liability for the directors of the phoenix company. Personal liability arises only if either (a) Court permission is not given under section 386A; or (b) one of the exceptions in sections 386D to 386F is not applicable.

In terms of section 386A, Court permission is required for a director of a failed company, within a period of 5 years after the commencement of the liquidation of the failed company, to be:

• a director of a phoenix company; or
• directly or indirectly concerned in or taking part in the promotion, formation, or management of a phoenix company; or
• directly or indirectly concerned in or taking part in the carrying on of a business with the same or similar name to that of the failed company.

A phoenix company is defined, in relation to a failed company (a company that was insolvent at the time it was placed into liquidation), as a company that at any time before, or within 5 years after the commencement of the liquidation of the failed company, is known by a name that is the same or similar to the pre-liquidation name of the failed company.

A breach of section 386A, by acting without Court permission or under the shelter of one of the exceptions in sections 386D to 386F, results in exposure to personal liability for all of the ‘relevant debts’ of the phoenix company. The relevant debts are the debts of the phoenix company during the period when the person was involved in the management of the phoenix company and it was known by its pre-liquidation name or a similar name. Significantly, personal liability can also extend to a person (puppet) who is involved in the management of a phoenix company on the instructions of a person (puppet-master) who breaches section 386A.

Section 386A must be read in conjunction with the section 386E which means that Court permission is not required immediately. Instead, section 386E provides a grace period to obtain the Court’s permission of 5 working days from the failed company’s liquidation – which then provides the director/manager with an exemption for a window period which ends on the earlier of 6 weeks after the commencement of the failed company’s liquidation or the date the Court allows an exemption.

As noted above, other than seeking Court permission, there are further exceptions to personal liability in sections 386D to 386F. Chief amongst these is the ‘successor company notice’ regime in section 386D – which requires that all creditors of the failed company are put on notice by receipt of details about the phoenix company and the director’s involvement with the failed company.

The TSSN case

To date, there have only been a handful of cases affecting the phoenix company provisions. Typically, these arise where a director is seeking Court permission to become involved in the management of the phoenix company and thereby shelter in the exception provided by section 386A.

The recent High Court decision in Groves v TSSN Ltd (in liq) is described as being the first case considering an opposed application for permission for the director of a failed company to act as a director of a phoenix company, under section 386A.

In the case of TSSN, the applicant (Groves) was a director and shareholder of the failed company. TSSN’s business was that of growing ornamental trees, mostly for export and it had been successful until the GFC. Amongst other things, TSSN had acquired the assets of the well-known Duncan & Davies nursery business in Taranaki. After the company’s bank withdrew its support, Touchstone Capital Partners Limited (an investment company that invests in ‘turnarounds’ of underperforming or distressed businesses) agreed to fund a phoenix arrangement whereby the business was sold to a new company.

Unfortunately, it appears that the need for Court permission for Groves to be a director of the phoenix company was overlooked. TSSN was put into liquidation and application was made, 7 months after the liquidation, for permission for Groves to be a director and take part in the management of the phoenix company. That application was opposed by the liquidators of TSSN.

Drawing on English case law, Justice Mackenzie said that the two principal considerations were:

• the consequences for the phoenix company and those having dealings with it, of Groves remaining (or not remaining) as a director and/or involved in the company’s management; and
• whether Groves was a person whose conduct in relation to the failed company or the phoenix company made him unfit to be a director of the phoenix company.

The judge found that there would be detriment to the phoenix company if Groves was not permitted to continue to be involved in the company’s management – because of his experience and market contacts. However, he also found that there would be no similar detriment if Groves was not permitted to be a director, because his responsibilities were primarily of a management type rather than involving governance.

The judge also placed significant emphasis on his finding that Groves had remained a director of the phoenix company for several months after becoming aware that section 386A prohibited him from doing so without Court permission. This, he said, amounted to a serious offence and one which reflected adversely on his fitness to be a director.

The lesson from this aspect of the judgment is that phoenix company directors must either make use of the ‘successor company notice’ regime in section 386D so that all creditors of the failed company are put on notice or take advantage of the slim grace period in section 386E. In either case, quick action is required and there is unlikely to be scope for a retrospective approval under section 386A for someone who remains a director for any length of time. (In the UK, the commentary on the provisions from which sections 386A to F were derived often refers to the need for strict compliance with the letter of the requirements and the relevant timeframes.)

Further questions about the phoenix company provisions

Another interesting aspect of the judgment is the discussion about evidence submitted on the issue of whether the business was sold to the phoenix company at an undervalue. Ultimately, the judge concluded that he did not need to decide this issue and, instead, must focus on factors relevant to the future governance of the phoenix company. He continued by commenting that the transfer of the business is a fait accompli and any challenge to the transfer will have to be mounted in other proceedings. However, this is done only after the judgement gives some clear pointers as to how he considers such an issue would be decided and a statement (labelled a finding) that the evidence is not sufficient to establish, on the balance of probabilities, that a fair market value was obtained.

It seems clear that the judge’s reason is that he decided that the case could be determined in the narrow issue of Court approval for Groves to be a director. This is sign-posted because he said that permission should have been sought in a timely way and the objectives of the phoenix company provisions would be substantially undermined if permission was granted for Groves to continue as a director on the basis of an assessment by the Court, made long after the event, that the business was not transferred at an undervalue.

This is not a small point. One of the criticisms of the phoenix company provisions when they were first introduced was the lack of an effective targeting of the ‘mischief’ of phoenix companies, namely the risk of transfer of business and assets at an undervalue or creditors being misled. Indeed, one critique of the requirement for Court permission under section 386A was that it did not include a specific requirement that the applicant proves that the phoenix company acquired the business for value.

Issues such as whether the phoenix company is adequately capitalised or has sufficiently experienced people at the helm to limit the risk of a second failure also seem to be absent from the legislation. These are matters that have been considered in the UK. The judge in the TSSN case skirted the first point but provided a useful pointer on a knock-on aspect of the second. In relation to fitness for appointment, he said that it would be wrong to treat Groves, without evidence of misconduct, as if he were unfit to be a company director.

The TSSN case raises a practical question about what happens where, unlike this case, an application under section 386A is not opposed. In this case, there was clearly a significant amount of money at stake and this decision may only be the precursor to further proceedings taken by the liquidator (possibly backed by the IRD and/or ACC who had rejected settlement proposals). In other cases, including one I have stumbled across, there may be a number of small creditors each of whom has only small amounts at stake and who are unwilling to fund an orderly liquidation let alone involvement in proceedings. In such a case, there seems very little to guide the Court provided the observations about timeliness in TSSN are observed. In these circumstances, it is difficult to see how the Court gathers sufficient evidence to make a finding that there is no transfer at an undervalue or risk of creditors being misled. As a result, I am left wondering what a judge in these circumstances can reasonably be expected to do to be satisfied that variations on the failed company name are not used repeatedly by someone who continues to run the phoenix just as badly as they did the failed company.

The phoenix company provisions were seen as a low-cost statutory disincentive to the ‘mischief’ of phoenix company arrangements. The key finding, on timelines, in the TSSN case is useful and follows the path adopted in the UK. Equally useful however are the observations and findings in the judgment that illustrate the need for the Court to be satisfied, when being asked to exercise the discretion under section 386A, that the proposed arrangements contain adequate safeguards against that mischief.

If you would like more information about any of the matters discussed in this note, please contact me.