The Protection of Employee Entitlements in Insolvency: An Australian Perspective

(forthcoming).

Introduction

On 11 July 2012, The Age reporters Ben Butler and Clay Lucas provoked a storm by suggesting that payments to employees of insolvent companies from the taxpayer-funded General Employee Entitlements and Redundancy Scheme (GEERS) had soared fourfold in five years.¹ The article said that ‘[i]nsolvency experts believe directors of some troubled businesses are exploiting the system by trading until company cash reserves are exhausted because they expect GEERS will pay most of the entitlements they should have paid to their workers’. The article triggered predictable responses from both ends of the political spectrum. Australian Council of Trade Unions (ACTU) Secretary Dave Oliver called for laws allowing the federal government to pursue the personal assets of directors of companies which did not put aside enough money to pay employee entitlements when their businesses failed.² Immediately, Australian Industry Group Chief Executive Innes Willox reacted by condemning the accusation that employers are misusing the GEERS scheme.³

It is now time for all parties—unions, employer groups, insolvency practitioners, regulators and employees themselves—to consider how best to protect employee entitlements without unfairly targeting business owners and without unreasonably burdening the taxpayer. The most recent Australian Securities and Investments Commission (ASIC) statistics show that in just under a quarter of external administrations—liquidations and voluntary administrations—there are unpaid wages, leave and redundancy entitlements after the finalisation of the administration, and close to 44 per cent involve unremitted superannuation.⁴ A taxpayer-funded safety net scheme has been an accepted part of the social security landscape in Australia since 2000. In December 2012, it took the form of a legislated scheme, the Fair Entitlements Guarantee (FEG). To July 2013, these schemes have cost the Australian taxpayer approximately $1.3 billion, with only about $180 million recouped from liquidations. These schemes are vital to alleviate the consequences of non-payment of entitlements. If employees lose their jobs and their accrued entitlements—wages, annual leave, long service leave and redundancy pay—due to corporate insolvency, the effects can be significant. Individuals and families suffer great financial and personal hardship. Chapter 3 will show the gradual increase in the amounts payable under FEG and its predecessors. There was a significant rise in 2009–10 due to economic difficulties caused by the global financial crisis (GFC) and the downturn in manufacturing and retailing. A further rise in payments occurred because of the Gillard Labor government’s increase in the GEERS redundancy entitlement from January 2011. This ensured that every worker would get four weeks per completed year of service, rather than the previous system which limited the payment to sixteen weeks, or four years of service.

Whether employers are exploiting the availability of a taxpayer-funded scheme to divert employee entitlement money to other purposes in the dying days of their businesses is unclear. The fact is, a small minority of business owners have always used the payroll and unremitted pay-as-you-go (PAYG) taxes to prop up their failing companies, and there is no evidence that the federal government’s safety net has made the situation any worse. Much of the concern over lost employee entitlements and unremitted employmentrelated taxes occurred before the introduction of GEERS and its short-lived predecessor, the Employee Entitlements Support Scheme (EESS). The infamous corporate collapses of the late 1990s—Exicom, Grafton Meatworks, Cobar Mines, Oakdale Collieries, Braybrook Manufacturing and National Textiles—were all pre-GEERS, and indeed were instrumental in the introduction of that scheme in 2001, as well as its predecessor in 2000.

This is not to say that taxpayer-funded safety net schemes may not be having an effect on the employee entitlements debate. They may have taken the focus off the protection of entitlements when it comes to ASIC’s enforcement of the Corporations Act 2001 (Cth) (Corporations Act). This is considered in detail in chapter 5. Furthermore, employers may be more reluctant to contribute to industry-based entitlement protection funds on the basis that these entitlements are now covered almost completely, first by GEERS and then FEG. This will be discussed in chapter 6. However, the consensus among those interviewed for this project is that the moral hazard of directors walking away from their company’s unpaid employee entitlements stems from their limited liability as shareholders, rather than the availability of a taxpayer-funded safety net scheme.

The notorious cases of directors abusing the corporate form to steal from employees create the unfortunate impression that most directors behave this way. The reverse is true. The insolvency practitioners I spoke to as part of this study into the protection of employee entitlements stressed that ‘making payroll’ is the primary objective of most business owners. The employers are sometimes the ‘little guys’ as well. When the company collapses and the workforce is laid off, it is frequently as distressing for the owners as it is for the workers. However, there are exceptions—abattoir owner Stuart Ramsey being one. Mr Ramsey has been vigorously pursued by the Fair Work Ombudsman (FWO) for interpositioning a series of companies between the workers and their true employer for the purpose of avoiding payment of their entitlements.⁵ Similar stories can be told in relation to phoenix companies, most recently the subject of a PricewaterhouseCoopers (PwC) report commissioned by the FWO. Phoenix companies abuse the corporate form to avoid payment of liabilities as detailed in chapter 1. The PwC report estimated total losses to stakeholders—including employees and the Australian Taxation Office (ATO)—from phoenix activity of between $1.78 billion and $3.19 billion per annum.⁶

Fortunately, there are existing laws to punish directors who behave improperly. Directors are under a duty not to improperly use their position to gain an advantage for themselves or someone else, or cause detriment to the corporation.⁷ ASIC successfully used this duty against a number of directors of phoenix companies and their legal adviser in ASIC v Somerville.⁸ This duty is a civil penalty provision, allowing for a pecuniary penalty of up to $200 000 against the director,⁹ a compensation order in favour of the company,¹⁰ and disqualification of the director from managing companies in the future.¹¹ Dishonest breaches attract a criminal penalty and possible imprisonment.¹² Yet prosecutions for breach of directors’ duties in relation to non-payment of workers’ entitlements are very few and far between. Furthermore, the offence provision introduced by the Howard government in 2000 that penalises a person for entering into a transaction with the intention of depriving employees of their entitlements—s. 596AB of the Corporations Act—has never been successfully used.

This book does not claim to ‘solve the problem’ of lost employee entitlements where companies become insolvent. The words of James Guest, Chairman of the Victorian Law Reform Committee, in a 1994 report entitled Curbing the Phoenix Company should be borne in mind:

The general problem of limited liability companies affording excessive protection to the fraudulent and grossly negligent against the claims of creditors is at least 150 years old. The problem will never totally disappear, since the law, the courts and law enforcement agencies cannot give absolute priority to the prevention of loss over the encouragement to enterprise and the need to limit compliance and enforcement costs.¹³

Business is an inherently risky undertaking. Incorporation is intended to encourage investment and entrepreneurial risk-taking. No qualification is required to form a company or be a company director. Inevitably, some businesses, through inefficiency, mismanagement, product obsolescence or factors beyond the control of their managers, will fail. Creditors, including employees, will lose money. It is not helpful to the debate on protecting employees of insolvent companies to equate business closure with management transgression.

Nonetheless, some losses are attributable to improper activities by management, be they breaches of the law or exploitation of the corporate form. This is the category of losses that will hopefully respond to properly drafted deterrence laws and well-resourced investigations by regulators and insolvency practitioners. It is imperative to ensure that all employees who lose their entitlements due to business closure are able to recover these amounts because of their particular vulnerability, which sets them apart from other creditors. This vulnerability is explained in chapter 1. It is also proper to deter the abuse of management’s position of power in a company where it has an adverse outcome for employee entitlements. Both purposes are legitimate objectives of government policy and law reform, but they should not be conflated. I strongly believe that political ideology and the struggle for power should not be the determinants of a solution.

Unfortunately, it is difficult to get any sense at all of the quantum of losses attributable to management’s illegal or immoral behaviour. Chapter 5 contains some statistics on the number of reports by insolvency practitioners of suspected breaches of various provisions of the Corporations Act. These statistics do not, however, quantify the deficiency in the business’ assets which is attributable to these suspected breaches. Moreover, there is no way to estimate accurately the losses to employees as a result of legal, but morally suspect, corporate manoeuvres which allow a business to move on and leave behind its losses.

Motivation for this Book

This book came about through the generous support of the Australian Research Council (ARC).¹⁴ It arose from research into directors’ personal liability and the theoretical underpinnings of creditor protection. In a world where company shareholders enjoy limited liability, creditors have no recourse to the company’s owners and are expected to protect themselves against loss. One of the ways in which they do this is through diversification. The default of one debtor is not a catastrophe if the creditor is owed money by many. For example, virtually everyone owes the ATO money and therefore the negative impact of the default of a small number of taxpayers is substantially reduced. Employees, on the other hand, are generally unable to diversify away their risk of loss, and the impact of their employer’s default on payment of entitlements can be immense.

It is therefore dismaying to discover that the director penalty regime, introduced in 1993 and considered in chapter 4 of this book, placed heavy penalties on directors for unremitted income tax instalments, but that legislation introduced in 2000 to protect employee entitlements¹⁵ had never been effectively used. It is a criminal offence under s. 596AB for a person to enter into a transaction with the intention of depriving employees of their entitlements. Although it was possible that the new laws had deterred all miscreants from their improper behaviour, the more likely reason for the section’s lack of use was the near-insurmountable requirement of proof of the directors’ actual intention beyond reasonable doubt, as though directors would discuss their improper intentions openly and record them in the minutes of their board meetings. Yet despite objections to the legislation, both before and after its passage through federal parliament, and despite its lack of use, this section remains in force today. It is referred to throughout this book, and its genesis is detailed in chapter 2.

The almost contemporaneous introduction of the taxpayerfunded EESS, the forerunner of GEERS and of the later FEG, led me to conclude that much of the impetus for law reform had been taken away. I undertook this project to investigate whether there are ways to safeguard the entitlements of employees that are presently lost through the improper behaviour of directors, without affecting legitimate business activities. I believe the project has achieved that objective, and this book makes the case for how it can be done. What the project has discovered is that there is no straightforward ‘solution’ of universal application. This book therefore offers a range of complementary means that will lessen, rather than eliminate, the loss of employee entitlements.

This Book’s Content

This book is divided into three broad parts. The first part, contained in chapter 1, addresses ‘the problem’ of loss of employee entitlements and contains some case studies which illustrate specific concerns. It analyses the unique vulnerability of employees as creditors and why they are deserving of special protection. It also introduces the reader to the concept of phoenix activity, where the corporate form is misused to defeat the legitimate claims of creditors.

The second part, contained in chapters 2 to 6, sets out ‘responses’. Chapter 2 provides a detailed account of the federal government’s actions in the late 1990s after a series of corporate failures put pressure on the government to act. This included the passage of the legislation noted above. This chapter also outlines the priority payments enjoyed by employees over other unsecured creditors in liquidation. Chapter 3 considers the government’s various taxpayerfunded safety net schemes—the EESS, GEERS and FEG—as well as the special scheme for Ansett employees. Chapter 4 examines legislative and policy developments since 2000, and in particular looks at the recent measures taken to address phoenix activity. Chapter 5 considers enforcement action by ASIC and the Department of Education, Employment and Workplace Relations (DEEWR).¹⁶ Chapter 6 looks at how labour law has tackled the issue of unpaid entitlements, including actions by the FWO and the union movement.

The final part, predictably, provides ‘possible solutions’; these are contained in chapters 7 to 9. There has been a vast range of solutions suggested by local and international commentators, politicians, business representatives and unions. Chapter 7 looks at director-related matters, such as the imposition of personal liability, reverse onuses of proof and specific penalties for phoenix activities. It also addresses director disqualification and suggests ways to improve enforcement by regulators. Chapter 8 considers encouragement towards prompt entry into voluntary administration (VA) or liquidation, and asks whether it is worth forgoing possible director liability if it means the unpaid amounts accruing to employees do not escalate. This question is prompted by the current existence of VA as a ‘safe haven’ against insolvent trading liability, and of VA and liquidation as means of avoiding liability for unremitted taxes. The aim of chapter 8 is to assess whether either current mechanism could be adapted to address the protection of employee entitlements. Chapter 9 then considers a range of other solutions mooted earlier in the book. These solutions include providing for employee entitlements prior to insolvency, safeguarding employee entitlements through ‘superpriority’, and designing special solutions to address losses of entitlements within corporate groups. This chapter is followed by some concluding thoughts.

How the Research Was Conducted

This book drew on a vast array of sources for its information. The traditional ones—cases, legislation, parliamentary debate, explanatory memoranda and scholarly commentary—provided the foundation. Media reports and websites were invaluable. Empirical data were sought directly from the regulators. Lengthy interviews were held with unions, regulators, insolvency practitioners and others. As a result of this broad study, the book is scholarly in its approach but grounded in numerous case studies arising over the past fifteen or so years. Its approach is neither pro-business nor prounion. In the end, it aims to present a balanced view of a difficult but not intractable dilemma.

Some limitations of the research should be noted here. This book does not recount every case of lost employee entitlements, every intervention by regulators or unions, every relevant comment by members of parliament or lobbyists, or every word written on the subject by scholars and commentators. Some have been omitted because they would be repetitive. Others, of course, escaped the eye of the author and her research assistants. To keep this book to a manageable size and to enhance its readability, large amounts of detail have been omitted. Much of this is available through my other publications on employee entitlements, listed in the bibliography, and readers are welcome to email me too.¹⁷ I have also omitted any more than a passing reference to sham contracting, the non-payment of independent contractors, and the employees of unincorporated businesses. I acknowledge that these are all cases where employee entitlements are threatened, but I could not do those topics justice in the space available and therefore I concentrated on employees affected by corporate insolvency. Similarly, a full international comparison is beyond the scope of the book,¹⁸ although occasional references are made to relevant comparative provisions overseas.

Nonetheless, I believe this book provides a comprehensive account. In my interviews and conversations with businesspeople and colleagues, I was surprised by how little people remembered of the reasons for the current environment concerning the protection of employee entitlements, and in some cases, how wrongly they recalled events. Plenty of worthwhile suggestions for reform have been made over the years, yet we seem to be asking the same questions again and again. By setting out the past and present problems of employee entitlements in insolvency, this book aims to give those interested in its reform the information needed to make well-considered decisions.

In doing this research, I got a sense that corporate collapses were seen as victimless transactions, part of the hurly-burly of ‘the way things work’. After all, the sensible secured creditors would enforce their security, the unsecured creditors could write off the debt on their tax, and the employees would get the GEERS or FEG money. So what’s the problem? The answer is that all taxpayers are the victims, both through their support of the safety net scheme and through the reduced revenue that the ATO receives where there is no remittance of employee taxes. The marketplace also loses where incompetent players are allowed to re-enter the field and cause the inefficient allocation of capital to their businesses.

All parties have a role to play in detecting company controllers who have behaved improperly in relation to their employees’ entitlements, through phoenix activity or otherwise. There need to be efficient mechanisms for reporting suspected breaches to ASIC, the FWO and the ATO, and appropriate resources allocated to the enforcement of the law. There needs to be finetuning of some existing legislation to overcome inherent difficulties with its enforcement. If there is a concern that reliance on the taxpayer-funded safety net is becoming unsustainable, the approach of increased enforcement of the law should reduce any suggestion that directors are improperly relying on it.

Notes

1 Butler and Lucas, ‘Failed Firms Leave Huge Tab for Taxpayers to Pick Up’.

2 Butler and Lucas, ‘Directors Must Be Forced to Pay’.

3 Willox.

4 ASIC, Report 372 , Table 26. These statistics are discussed in chapter 5.

5 Fair Work Ombudsman v Ramsey Food Processing Pty Ltd (No. 2) [2012] FCA 408 (20 April 2012). See also Fair Work Ombudsman v Ramsey Food Processing Pty Ltd [2011] FCA 1176 (19 October 2011).

6 PwC, ‘Phoenix Activity: Sizing the Problem and Matching Solutions’, pp. iii, 15.

7 Corporations Act 2001 (Cth) ( Corporations Act ) s. 182.

8 [2009] NSWSC 934. The directors also breached Corporations Act ss. 181 and 183.

9 Corporations Act s. 1317G.

10 Ibid., s. 1317H.

11 Ibid., s. 206C.

12 Ibid., s. 184.

13 Victorian Law Reform Committee, Curbing the Phoenix Company: First Report , pp. xvi–ii.

14 See Australian Research Council, ‘DP1092474: Reform of the Personal Liability of Directors for Unpaid Employee Entitlements’ (2010–2012).

15 Corporations Law Amendment (Employee Entitlements) Act 2000 (Cth), which inserted pt 5.8A into the Corporations Act and amended pt 5.7B.

16 Since 18 September 2013, the employment-related functions of this department have been carried out by the Department of Employment.

17 Please contact me at h.anderson@unimelb.edu.au . Where my information has been obtained from websites, I can provide the URLs but note that the continued availability of the information at the particular site is beyond my control.

18 See the excellent book by Janis Sarra, Employee and Pension Claims during Company Insolvency: a Comparative Study of 62 Jurisdictions (Thomson Carswell, 2008).

1

Employee Vulnerability

Introduction

Corporate failure will, and always should, exist. In a Darwinian sense, the economy is stronger if inefficient businesses fail. However, insolvent companies almost inevitably leave creditors without full payment of their debts. When rights in insolvency are discussed, employees are often addressed separately from ‘creditors’, but they are indeed creditors, albeit with statutory priority over other unsecured creditors in winding-up proceedings.¹ The aim of this chapter is to set the scene for a consideration in chapters 2 to 6 of the responses to losses of employee entitlements by governments, regulators and unions. It examines the reasons why employees are more vulnerable at times of corporate collapse than trade creditors and why special protections are justified for them. Fraudulent phoenix activity, where a company is ‘killed’ and the business arises again in another corporate form without its debts, poses a special threat to the payment of employee entitlements and is also examined in this chapter.

The corporate collapses set out below are not here to make the point that ‘someone should have done something’ to avoid these insolvencies. Rather, the chapter recounts the stories of the major corporate failures at the end of the last century to illustrate the foundations of our current system of employee entitlement protection.²

Why Employees are Vulnerable to Corporate Collapse

In order to understand the reasons that all creditors, but particularly unsecured creditors such as employees,³ are vulnerable to corporate collapse, it is necessary to return to the fundamentals of corporate law.⁴ There is a naturally occurring divergence of interest between companies and their creditors. Each wants to give as little as possible and gain as much as possible from their dealings with each other. To save every company from having to negotiate every term in every contract it makes, corporate law provides a set of enabling rules to facilitate business.⁵ These include the separate legal personality of the corporation, the limited liability of its shareholders, the transferability of their shares, delegated management under a board structure, and shared ownership of the corporation by contributors of capital. While these five basic characteristics of incorporation are not enjoyed by all companies,⁶ these standard rules generally reduce the cost of transacting.⁷

The two enabling rules of particular interest for insolvency are the separate legal personality of a company and the limited liability of its shareholders. Separate legal personality allows companies to own assets and to pledge them as security to creditors in exchange for debt capital. Companies have the flexibility to finance their activities by debt or equity capital, or a combination of the two. Shareholders, or their personal creditors, have no access to company assets; equally, company creditors have no access to the personal assets of shareholders.⁸ The separate legal entity of the company and the limited liability of its shareholders shift some of the risk of loss from shareholders to creditors. While creditors are paid before shareholders in a liquidation, a company becomes insolvent if it is not able to pay its creditors in full when their debts fall due.⁹ Sole traders and partners in a partnership risk their homes, investments and other personal assets when conducting business through these forms because the law does not recognise a distinction between the business and its owners. In contrast, the potential amount of each shareholder’s loss upon corporate insolvency is finite and known,¹⁰ which gives shares a stable price and aids their transferability. Because of this, investors are encouraged to invest in shares, and to minimise the risk of doing so by diversifying their share portfolios.¹¹ This wide investment is crucial to funding businesses and thus to providing employment.

There is nothing inherently improper, therefore, if shareholders are absolved of liability for the debts of the companies in which they have invested, and this is so regardless of whether those shareholders are individuals or themselves companies. By providing these fundamental standard-form terms, which parties would otherwise have to negotiate and contract for individually, corporate law plays an important role in facilitating the pooling of capital, the growth of the economy and the pursuit of business objectives.¹² Businesses operating as companies create the most employment. Without the characteristics of separate legal entity and limited liability, businesses would remain small and their owners would continue to manage them as sole traders or through partnerships, as a way of limiting their personal exposure to the businesses’ debts.

Inevitably, the ability of companies to borrow and purchase on credit, coupled with the limited liability of their owners, leads to a risk of non-payment. This problem is made worse if the company is undercapitalised, which is quite legal in Australia,¹³ or deeply in debt. The ability to incorporate companies with the barest of capital encourages the incorporation of dozens of these separate legal entities in the corporate group setting, as well as their ready liquidation without payment of creditors’ claims. Moreover, abuse of the corporate form through phoenix activity can occur when limited liability shields shareholders from the company debts. This issue is discussed below.

The consequences of non-payment of specific debts upon the company’s insolvency can be addressed in two ways—either by protection mechanisms put in place before the contract is entered into (ex ante) or via remedies made available after the company has failed (ex post). One ex ante means of creditor self-protection is diversification, which refers to the technique of minimising the risk of one party’s default by dealing with a number of different parties. The non-payment of one debt is a small, easily absorbed loss rather than a catastrophic blow to the creditor, which may lead to the creditor’s own liquidation or bankruptcy.

Creditors can also protect themselves ex ante against the risk of a debtor’s non-payment by charging more for all of the goods and services they provide. They may obtain security by requiring personal guarantees from company directors, mortgages and other security interests over the company’s assets, or covenants restricting the company’s ability to sell or further pledge its assets.¹⁴ Access to information about the company’s financial position is another important ex ante means of creditor self-protection. Directors, shareholders, banks and secured creditors are likely to be privy, to varying degrees, to information that enables them to see the warning signs of corporate failure and to act to protect their interests. Sometimes the legal instruments that provide security to creditors afford them a vital source of information about the company’s financial performance, through contractual provisions imposing reporting obligations on the borrower or allowing the lender to appoint accountants to look into the company’s affairs when concerns arise.¹⁵

On the other hand, employees, technically ‘voluntary’ creditors, ¹⁶ face special difficulties in utilising any of these ex ante means of self-protection.¹⁷ Unlike other creditors, employees generally do not have the ability to diversify their risk.¹⁸ For the vast majority of employees, all of their human capital is invested in a single company. ¹⁹ Using 2001 data, Davis and Burrows estimate that Australian employees’ accrued entitlements ‘probably exceed $50 billion, an amount approximately equal to total lending by all finance companies’. ²⁰ In times of high unemployment, employees may face a difficult decision between unemployment and a financially unstable employer. While senior employees can demand higher pay for running the risks associated with possible corporate financial instability, rank-and-file workers are rarely able to negotiate for additional compensation. Unlike a bank or substantial trade creditor, they also generally lack the power to seek security over the company’s assets.²¹ In fact, the ability of some creditors to protect themselves—for example, with security over company assets or loan covenants—increases the risk to weaker parties who cannot negotiate such protection,²² as fewer assets remain unencumbered for realisation and distribution by the company’s liquidator.

An employee’s lack of information about the company’s financial position, both before and during their contract of employment, worsens their position.²³ Directors and corporate managers may take on risky projects, or refinance or reorganise the corporate entity, which adds to the likelihood that employees will not recover their full entitlements.²⁴ Ordinary employees lack the power to prevent management increasing the risks facing the company. The vulnerability of employees worsens when a company is on the brink of failure. The directors, representing the company’s controlling shareholders, may seek to benefit themselves or other companies in the group at employees’ expense.²⁵ Deliberate strategies to avoid payment of their entitlements may also hurt employees.²⁶

To overcome the deficiencies in the ability of creditors to selfprotect ex ante, the law provides a range of means to protect them ex post. The first is the collective distribution regime in liquidation allowing redistribution of assets through the prioritisation of the claims of some, such as employees, over others; ²⁷ the second is the availability of, and encouragement towards, corporate reorganisation or rehabilitation; and the third is imposing personal liability on others such as directors or holding companies in certain circumstances.²⁸ Each of these means of protection is addressed in subsequent chapters of this book.

Given that a receiver outside of, and prior to, the liquidation process enforces secured creditors’ claims, the division of the corporate estate via a collective system may result in little return for unsecured creditors, even priority unsecured creditors such as employees.

While Bronstein conceded the importance of priority, recovery by employees:

depends even more on whether there are any assets left. The ranking of the preference and its extent can be determined by the law, but no rule of law can determine in advance what assets—if any—will be available … This explains why the prevailing view is that the only adequate way to protect wages is to remove protection from the realm