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ACTING EARLY CAN SAVE A BUSINESS

BACKGROUND

A husband and wife were directors of a company that operated a manufacturing business. The husband had day-to-day control of the business while the wife didn’t have too much involvement with the business, as she was raising the family. The company had been in business for over 15 years and had always operated profitably. In recent years the company purchased some newer plant and equipment that was financed by their bank. It was a big commitment, but the directors believed the income was sufficient to service the increased debt.

The business fell on tough times. There was increased competition that led to very competitive pricing. The pressure pushed the company to quote very lean margins, and in some cases the jobs were actually running at a loss. The director thought that as cash was coming in the door and the bank account had funds, that things couldn’t be too bad. Unfortunately, one of the company’s largest customers went into liquidation and the outstanding debt owing by this debtor was over $450,000 and was not recoverable. The significantly impacted the business’s cash-flow.

It was at this point the directors met with their accountant. The accountant reviewed the position and they discussed some options that would save expenses including reducing overheads, more accurate and selective tendering, negotiating a repayment agreement for the outstanding tax debt, and the redundancy of surplus staff. The directors put these strategies into place and traded on for the next 12 months. Unfortunately, the position didn’t improve as the company was still recovering from the cash-flow loss from the previous 12 months. The company struggled to compete in the tough market environment and the work they were winning had very little profit margin.

Given the company was still struggling to pay its creditors, the directors again met with their accountant to review the position. At this point the accountant determined it was appropriate to seek the assistance of an insolvency practitioner to assess the position. The insolvency practitioner’s analysis of the company’s financial position confirmed the following:

ASSETS
Plants & equipment $850,000
Debtors $650,000
Cash at bank Nil as running overdraft

LIABILITIES
Overdraft (secured) $100,000 (limit was $200,000 – therefore $100,000 was still available)
Chattel finance (bank) $950,000
Trade creditors $700,000
GST $150,000
PAYG $50,000
Superannuation $55,000
Accrued employee entitlements $125,000
Termination payments $100,000

INSOLVENCY OPTIONS

It was clear the company was insolvent and therefore unable to meet its due and payable debts. The insolvency practitioner outlined the director’s options. These included the following:

  1. Do nothing.
  2. Close the doors and put the company into liquidation.
  3. Place the company into voluntary administration with a view of putting forward a Deed of Company Arrangement (DOCA).

The insolvency practitioner ran through each of the options and their ramifications.

Option 1

Do nothing – the position was not going to improve. The company was using all of its available cash to make the plant and equipment repayments, and some creditors were aggressively demanding payment. As a result the GST, PAYG withholding and superannuation were getting further and further behind. The insolvency practitioner explained the potential ramifications of the taxman issuing a director penalty notice, making the directors personally liable for the unpaid PAYG withholding and superannuation. The insolvency practitioner urged that doing nothing really wasn’t an option.

Option 2

Put the company into liquidation – if the directors took action now the liquidators would collect all debtors, collect and sell the plant and equipment. The debtors’ funds would payout the employee entitlements in full, with the balance paid to the bank under their security interest over the company. The plant and equipment proceeds would pay the bank under their charge. After paying the employee entitlements and the bank, the rate of return to unsecured creditors would be 14 cents as outlined below:

Recovered debtors$650,000
Proceeds paid to employee
entitlements (both accrued
and termination)
$225,000
Surplus debtors funds$425,000
Proceeds from sale P&E$850,000
Chattell financier (bank) debt$950,000
Shortfall suffered by bank$100,000
Plus outstanding secured
overdraft
$100,000
Amount still owing to bank$200,000
Surplus debtors funds$425,000
Less amount still owing to bank$200,000
Available funds$225,000
Less liquidators fees$100,000
Funds available for
unsecured creditors
$125,000
Total creditors
(including trade creditors, PAYG and GST)
$900,000
Dividend rate14 cents

Option 3

Place the company into voluntary administration – with a view of putting forward a DOCA. After much discussion it was determined that if the company didn’t have to meet the ATO repayment amount and the old debt, the company would be able to put forward a DOCA proposal whereby an amount of $10,000/month for three years would be available to pay creditors. The amount would be in addition to the deed administrators retaining 50% of the debtor’s funds for the benefit of creditors. The other 50% would be required for working capital and to pay down the overdraft, and some of the plant and equipment debt, which were the bank’s requirements. Under the DOCA, the company would continue to pay the monthly payments to the bank and the employees would retain their jobs. The DOCA effect means there would be no crystallisation of the financed debt of $1,050,000, nor the employee entitlements of $225,000.

The rate of return to the unsecured creditors, under this option would be as follows:

50% of debtor funds$325,000
Monthly DOCA contributions
of $10,000 for 36 months
$360,000
Total funds available for creditors$685,000
Less VA and DOCA fees$150,000
Less superannuation
(which must be paid in full)
$55,000
Funds available to unsecured
creditors
$480,000
Dividend rate53 cents


It was abundantly evident the company could not continue. The insolvency practitioner advised the directors that they had no choice but to put the company into liquidation. The directors reluctantly agreed.

Unfortunately the company’s financial position meant the liquidator was unable to trade on the business, and the doors were closed. As a result the employees were all made redundant and the liquidator collected and sold all of the assets of the company.

The following summarises the liquidator’s recoveries:

Recovered debtors $150,000
Outstanding employee 
entitlements (including
superannuation)
$225,000
Shortfall on debtors funds 
(this was topped up by the
government’s Fair Entitlements Guarantee (FEG) scheme)
$75,000
Proceeds from sale of P&E$750,000
Chattell financier (bank) debt$850,000
Shortfall suffered by bank$100,000
Plus outstanding secured
overdraft
$200,000
Amount still owing to bank$300,000
Total creditors
(including trade creditors,
 PAYG and GST)
$1,490,000
Dividend rateNil

As can be seen above, the bank suffers a shortfall of $300,000 and therefore no funds are available to pay creditors any dividend at all.

The effect on each stakeholder is summarised as follows:

FALLOUT EFFECTS

Employees.
All employees were terminated and therefore were unemployed. Some debtor recoveries enabled superannuation to be paid and some other entitlements, but it was insufficient to pay their entitlements in full. As a result the governments FEG scheme stepped in to fund the remaining entitlements. While the FEG scheme guarantees the payment of employee’s leave and redundancy entitlements (up to capped limits) the scheme takes up to six months to distribute, making employees unemployed, and unpaid.

Bank.
The bank suffers a $300,000 shortfall from company assets. As a result, the bank enforced the directors’ personal guarantees and applied the shortfall against the director’s home. This meant the bank enforced their rights over the property and forcing a sale of the directors’ personal home. There was insufficient equity in the sale of the home to satisfy the bank debt in full.

ATO.
Given the company had outstanding lodgements for PAYG withholding and GST excess of three months, the ATO exercised its rights to issue a DPN upon each of the directors. The DPN made both directors automatically liable for the outstanding PAYG for $90,000.

The insolvency practitioner confirmed option 3 was the best option for these reasons:

  1. The bank is paid in full.
  2. Employees retain their jobs.
  3. Company continues to trade, and therefore ongoing work for suppliers.
  4. The creditors get substantially more – 14 cents in the liquidation scenario vs 53 cents in the VA scenario.

The insolvency practitioner suggests the directors sleep on it and decide which course they want to take.

ACTION TAKEN (OR NOT TAKEN)
Unfortunately, the directors went back to their old ways. While they appreciated the issues at hand, they refused to accept they needed to deal with it now, and thought that things would get better if they made more effort to manage the business correctly.

Over the following 12 months things got much worse for the company. Competitive pricing was still making good margins difficult. The creditors were now very overdue and increasing the pressure to pay up. Some creditors threatened to cease supply. As a result, the company stopped lodging tax returns, wasn’t remitting superannuation, PAYG withholding and GST, and used this money to pay the creditors that were aggressively seeking payment.

The directors then received a director penalty notice (DPN) from the Australian Taxation Office (ATO), which outlined that the company had failed to meet its PAYG withholding and superannuation reporting obligations – making the directors personally liable for an estimated $170,000. By the time the directors acted on the DPN, the notice’s 21-day deadline had expired. Their accountant arranged another meeting with the insolvency practitioner. The insolvency practitioner confirmed the directors were personally liable for the DPN, and unless paid in full, the ATO could bankrupt them. The directors confirmed they did not have the funds to pay the $170,000 DPN.

The insolvency practitioner then assessed the company’s current financial position, which was as follows:

ASSETS
Plants & equipment$750,000
Debtors$350,000
Cash at bankNil as running overdraft

LIABILITIES
Overdraft (secured)$200,000
Chattel finance (bank)$850,000
Trade creditors$1,050,000
GST$350,000
PAYG$90,000
Superannuation$85,000
Accrued employee entitlements$125,000
Termination payments$80,000

It was clear the position was significantly worse than it was 12 months prior. The significant changes were as follows:

  • Debtors – these had decreased due to the company’s inability to secure sufficient work. Most of the remaining debtors were outstanding for some time, and it was questionable just how collectable those debtors would be.
  • Overdraft – the overdraft was used up to the facility limit ($200,000) as the company was forced to use all possible means to pay creditors. The overdraft facility was secured to the bank.
  • Trade creditors – the creditors had increased due to the company’s inability to generate sufficient cash-flow and most creditors were at least 60 to 90 days overdue.
  • GST/PAYG withholding superannuation – the company was unable to meet its GST obligations and as a result these debts had increased.
  • Employee entitlements – the employee entitlements had decreased as some employees were made redundant and others were forced to take paid leave given the decrease in work.

Landlord.
Given the company vacated the premises with minimal notice; the landlord was without a tenant and unpaid rent. Further the landlord suffered ‘make good’ costs to make it attractive for a new tenant. Given there was no dividend to unsecured creditors the landlord then exercised their rights under the personal guarantee and demanded payment of the outstanding rent and the make good from the directors personally.

Unsecured Creditors.
There was no dividend to unsecured creditors and therefore these creditors had to write-off any outstanding debt, as a bad debt.

Directors.
The directors lost their home when the bank took possession and sold the house. Further, there were numerous creditors, including the ATO, landlord and other personally guaranteed suppliers that took action to recover their debts from the directors personally. Consequently the directors were forced to file for bankruptcy.

Summary.
This story happens all too often. The events earlier gave the opportunity for the directors to take action that would have avoided the company liquidation and its fallout effects. However, out of simple stubbornness the directors chose not to act upon the proper advice of their accountant and insolvency practitioner and paid a very hefty price. Had they put forward the DOCA, assuming it was accepted, the following would have happened:

  • The company would have avoided liquidation and it fallout effects.
  • The employees would have kept their jobs.
  • The bank would have received all of their funds.
  • The landlord would have retained a tenant.
  • The unsecured creditors including the ATO, would have received more than half of their money and retained a customer.
  • The directors would have had limited exposure to personal liability for company debt and avoided liquidation.

Instead everyone else lost.

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