This is the next in our continuing series of notes examining how the COVID-19 pandemic has affected mergers and acquisitions. Here we focus on the unwind risk in distressed M&A, i.e. the risk that transactions entered into by a financially distressed business may be unwound (reversed) if the company is later placed into liquidation. We consider this risk particularly from the point of view of the purchaser of these assets.
Some background. It is fairly common for failing companies to restructure their operations and reduce costs; for example standing down staff, closing non-core operations or divesting parts of the business.
If the company later goes into liquidation, then the liquidator may decide some of these pre-liquidation transactions are voidable, i.e. they should be unwound. This is a material risk for any purchaser looking to transact with a distressed entity.
In this article:
- we review the recent decision in Rimfire;
- we examine the legal framework that applies to voidable transactions, particularly those dealing with the transfer of a company’s assets or business at an undervalue;
- we suggest some practical ways in which a purchaser can seek to structure these transactions to minimise the unwind risk. Particularly, the importance of valuations and market testing, as well as putting in place proper documentation around the transaction.
The recent decision of the Queensland Supreme Court in Rimfire Constructions (Qld) Pty Ltd (in liq) v CRCG-Rimfire Pty Ltd is helpful. Before it was ultimately placed into liquidation, Rimfire had agreed to construct two building projects.
However Rimfire got into financial difficulties and agreed to transfer (by novation) the two construction contracts to another company. It was claimed in Court that this transfer was voidable because the payment Rimfire received was much less than the value of the contracts. It was said the transfer was should be set aside because it was uncommercial.
Although the case was decided on other grounds, the Court also considered whether the transfer should be set aside. While in one sense the transfer was for an undervalue, the Court found that Rimfire’s poor financial position meant it was unlikely to be able to complete the projects in its own right. For example, it was unable to pay trade creditors to complete the projects. Hence the Court felt that Rimfire did not lose a certain entitlement to profit, rather it lost the chance of making a profit if it had been able to complete the projects (which it was unable to do).
Having regard to all the circumstances the Court decided the transaction was not uncommercial.
This case illustrates some important propositions, including:
- a transaction must be commercial, otherwise there is an unwind risk where a liquidator is later appointed to the seller company;
- however, the commerciality of a transaction is not based solely on the notional value of the assets in question, in this case the construction contracts. The transaction must be examined in the whole context of its ramifications for the company, not as an isolated event. In this case, the circumstances of Rimfire were relevant to the assessment of the benefits received and detriments suffered by entering into the contracts. The Court was not convinced a reasonable person in the position of Rimfire would not have entered into the transactions.
When the modern companies law first emerged in Britain, creditors had only limited rights following a corporate failure. Since then, the law has developed to provide some significant creditor protections. These include giving liquidators the power to attack and unwind some transactions which occur before their appointment. Generally these only apply once a liquidator is appointed.
The Corporations Act deals broadly with two types of voidable transactions. One type is where a company undertakes a financial transaction, such as repaying a debt owing to a creditor (which can be an unfair preference) or borrowing money at extortionate rates.
Another group of potentially voidable transactions involves where a failing business disposes part or all of its assets and business at an undervalue. Transactions between a company and its directors (and their associates) typically raise red flags to company administrators and creditors, particularly where these are poorly documented or unsupported by valuation.
The table below summarises some of the more common ways in which liquidators can seek to unwind transactions.
Table 1 | Overview of Voidable Transactions dealing with assets of businesses
|Type of voidable transaction||Description||Commentary|
|Uncommercial transactions||A transaction into which a reasonable person in the company’s circumstances would not have entered.||This applies to transactions entered into, (or an act was done for the purpose of giving effect to it), during the two (2) years ending on the relation-back day.
An example is where a company sells a business or asset at an undervalue.
Other examples may include: gifts, tasks performed for no consideration, overpayment for goods or services, or the provision of securities or guarantees to previously unsecured loans.
|Unreasonable director-related transactions||This is a transaction with a director ( or a director’s associate or a person acting on their behalf).
A reasonable person in the company’s circumstances would not have entered into the transaction.
|This applies to transactions entered into up to four (4) years ending on the relation-back day; or after that day but on or before the day when the winding up began.
An example is the sale of a business or asset at an undervalue to a director.
Other examples include the payment of money, an issue of shares, or the conveyance or other transfer of property of the company.
|Creditor-defeating dispositions (Phoenixing)||These relatively new provisions (2020) aim to prevent companies defeating creditors through phoenixing.
Pheonixing is the practice of transferring a company’s assets to a new company, then placing the asset-stripped, debt-laden company into liquidation.
Some of the indicators of phoenixing include:
· the directors of the new company are family members or close associates of the former company;
· the new company trades under a similar name to the former company;
· the new company continues to operate from the same business premises and use the same contact details.
|The transaction is voidable if the transaction was entered into, (or an act was done for the purposes of giving effect to it), when the company was insolvent, during the 12 months ending on the relation-back day, or both after that day and on or before the day when the winding up began. (Other provisions also apply.)|
Some recent developments
Recently, the insolvency laws have been temporarily changed in response to the pandemic. For example:
- there has been an increase in the minimum threshold for creditors looking to issue a statutory demand (to $20,000);
- the timeframe within which a company may respond to a statutory demand has increased from 21 days to six months;
- there have also been attempts to relax the liability of company directors for allowing a company to incur debts while insolvent.
While these changes may allow some companies to trade on longer than otherwise, they do not affect the law relating to voidable transactions outlined above.
This is important because there has been considerable speculation that the government stimulus package is artificially propping up ‘zombie companies’. These are businesses which are essentially otherwise insolvent and would have failed in ordinary circumstances. The extended grace periods outlined above gives these businesses a longer time period into which to enter into voidable transactions (such as those outlined above) than would otherwise be the case.
As the currently scheduled government stimulus winds down in Q4 2020, commentators speculate this will lead to a tsunamai of corporate collapses. In this case, company liquidators will no doubt be looking closely at pre-appointment transactions, including asset and business transfers entered into during these extended grace periods.
Some of the practical steps which a purchaser can take to mitigate this risk include:
- Checking that the seller conducted, or attempted to conduct, a sale process, e. put the asset on the open market;
- Organising an independent valuation of the business/assets;
- Negotiating arm’s length transaction documentation.
In the right case a sale process can be helpful in that the highest bidder will, by definition, determine the current value of the relevant asset. However there are some downsides to a sale process, including the time and cost required. Further, having regard to current volatile market conditions, in many cases there are simply no buyers – except perhaps management – for a distressed business. In such cases a sale process can be futile.
An alternative is to commission an independent valuation of the asset. However many previously reliable valuation methods (comparable assets, discounted cash flow) have become less valuable in the current highly volatile market.
This does not mean that valuation is hopeless. Acknowledging the vicissitudes of the corona-pandemic, the Private Equity and Venture Capital Valuation Board has put out valuation guidelines, with the reassuring observation that fair value can still be estimated by valuers who think critically in the current market.
Additionally, as shown by the Rimfire litigation, any valuation will need to take into account the seller’s circumstances. A company in dire need of liquidity for cash flow is obviously in less of a position to negotiate when compared to one that is fully capitalised. The law relating to voidable transactions does allow consideration of the company’s particular circumstances.
When there is a discrepancy between the proper, or perceived, value of an asset and the transaction price, efforts by the seller to explore multiple avenues of divestment and value assessments can provide some protection should the company later be liquidated. Retention of records of these efforts can be helpful later on in this case.
Negotiation of arms-length, market-based documentation can also assist in minimising the unwind risk. While documentation does not in itself mean a transaction is commercial or reasonable, it does provide a level of practical assurance to an administrator or liquidator that may be reviewing pre-appointment transactions. Conversely, the absence of documentation is often a red flag to insolvency practitioners and creditors that something may be amiss. Documentation also serves a more conventional purpose of identifying the assets that have been transferred and the consideration paid, providing certainty to the parties about as to what exactly is being transacted.
In the current environment, we suggest any purchaser for value of an asset from a distressed business should carefully consider these issues to minimise the risk the transaction is later reversed if the seller later goes into liquidation.
Keypoint Law is currently advising clients involved in transactions of the kind outlined above.
The author gratefully acknowledges the valuable advice and input from Penelope Pengilley, Consulting Principal at Keypoint Law.
 Rimfire Constructions (Qld) Pty Ltd (in liq) v CRCG-Rimfire Pty Ltd  QSC 92.
 In the Salomon case (1862) (Salomon v Salomon & Co Ltd  AC 22) a UK court found that unsecured creditors had no recourse against the owner of a failed boot repair business (who had sold the business to a company controlled by him) when the company subsequently collapsed. This is referred to as the corporate veil doctrine.
 The relation back day can vary depending on the circumstances but includes (for example) the date on which an application to wind up the company is filed, or the date on which a company’s winding up or administration begins. Longer time periods apply if the transaction is with a related party or for the purpose of defeating creditors.
 For an example of payment of money that was a voidable transaction, refer to: In the matter of Pulse Interactive Pty Limited (in liquidation) NSWSC 22; 134 ACSR 461
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please also note that the law may have changed since the date of this article.