From loss to profit at the stroke of a pen!

For the second time in a couple of months I’ve come across a business unable to arrange finance because it didn’t properly understand the way it had presented financial information to prospective lenders.  Once corrected, and more importantly, properly explained, finance was available on significantly better terms.

I’m not a tax practitioner* but my understanding is that it is perfectly legitimate for income tax purposes to value closing inventory at cost.  Doing so will defer the recognition of taxable income until the inventory is sold, likewise deferring the income tax bill – which is clearly extremely helpful in managing the cashflow of a growing business.

For businesses that carry the same amount of stock, year in-year out, the income tax treatment will “catch up” to the accounting treatment and there won’t be much difference in the medium term.  But for businesses that are growing, or have variable stock levels, the difference can be quite significant.

In case 1 the treatment turned a healthy business into one that was marginally profitable, in case 2 it turned modest profits into large losses.  Significantly, it also meant that the projected gross margin was much higher than the historical gross margin.

In both of my recent cases, the external accountant had used the treatment without explaining it in a way that their client understood. That meant that the client was unaware of the need to explain the historical effect to lenders, and completely unable to explain the projected increase in gross margin, which, to a cynical lender, seemed to “magically appear” just when the borrower needed finance.

To have finance declined is bad enough, but even worse, I have also seen the same situation result in a borrower being transferred to “bad bank” – and then being asked to refinance.

The business banker of yesterday had the time to get into the numbers. In my examples, they may well have been able to work out what was going on, and “turn it into a deal.”  However, most of the bankers I meet today have many more opportunities than time to analyse them, and so deals that don’t appear to stack up are quietly put to one side, quite possibly without the potential borrower ever understanding why.   

More than ever, it is important for a prospective borrower have a well-written proposal that has already been “put under the microscope” and stress-tested, by an adviser that understands both banking and accounting, and how the two intersect.

*Take your own tax advice based on your own specific circumstances, please.

Missing pieces

On 24 September the Treasurer announced that Australia’s response to COVID-19 would include a new restructuring process, intended to make restructuring cheaper and more accessible for the smallest businesses.

Only two weeks later the draft Corporations Amendment (Corporate Insolvency Reforms) Bill 2020 (Cth) was released, with perhaps the shortest consultation period on record – 4 business days!

The draft legislation is a jigsaw puzzle with many missing pieces.  There are several important and significant parts that have been left blank, to be completed by later regulation.  Yes, it is possible to make educated guesses based on the Explanatory Memorandum and the Treasury fact sheet – but that is hardly a satisfactory way to review legislation.

One of the very pleasing aspects is that those responsible for the drafting have drawn heavily on the existing voluntary administration framework and definitions.  For that reason, many of the concepts and definitions are well developed and understood, and so we hopefully avoid the “what-does-that-mean” post-implementation chaos of the PPSR.

The process has been described as incorporating elements of the US Chapter 11 approach.  However, it’s not the big end of town Chapter 11, where every decision is made slowly and expensively in a Courtroom.  As White & Case explain, it draws on the “Subchapter V process,” and the key point is that the directors stay in charge of the business for all activities within the ordinary course of business.

Once appointed, a Small Business Restructuring Practitioner helps the directors prepare a restructuring plan.  It seems – but it’s not clear – that the SBRP will provide creditors with a recommendation to accept or reject the plan, which they will do electronically, with no physical meeting.  Between appointment and meeting day there will be a stay on creditor action which follows the voluntary administration moratorium.  

Mark McKillop summarises the detail we don’t have, noting that the regulations will specify:   

Surprisingly, nearly all of the functions, duties and powers of the restructuring practitioner.   There is a generic provision for basic functions like providing advice to the company on restructuring matters, assisting and preparing a restructuring plan, making a declaration to creditors “in accordance with the regulations” in relation to the plan and any other functions given to the practitioner under the Act.  Apart from that, the regulations are to provide…;

The form, content, making, implementation, varying, lapsing, voiding, contravention and termination of restructuring plans.    Regulations are also to provide for the role of the restructuring practitioner in relation to the plan….

At first glance, the proposed process is a cut-down version of voluntary administration.  It should be quicker and cheaper than VA, and there are eligibility restrictions which mean that a director can only invoke it on one occasion across all corporate involvements – so what’s not to like?

The biggest issue is that it is not clear whether small businesses will be able to access the process in practical terms:

  • The process is only open to companies up to date with “tax lodgements.” In the absence of the regulations it is not clear what that means – but potentially it may exclude companies with overdue income tax returns.

  • Companies are also required to have paid all “employee entitlements.” Again, it is unclear what that includes, but if it means that employee leave entitlements and so on must be paid out, that will impose a cash impost that will be too heavy for many businesses.

  • The SBRP has no liability for debts incurred after his or her appointment. That’s great for the SBRP – but many creditors will decide that it shifts the credit risk to them, and they may insist on CoD terms.  Businesses that can’t trade on CoD will be squeezed.

  • The remuneration for the SBRP is another aspect to be settled later by the Regulations – but it seems that the expectation is that there will be a fixed fee for the work up to the vote, and then a percentage commission on distributions to creditors for work done after the vote. If the Regulations do cap the fee and commission as some anticipate, then we might see SBRPs refusing an appointment because the work required to do the job properly is out of line with the fees available.

Within all the uncertainty there is the framework of a useful process.  Time will tell if the fleeting consultation process provides sufficient time to identify and iron out the wrinkles.  If it does, we will have a useful low-cost option added to the toolkit. 

Concessional RIC loans for farmers and small businesses impacted by Drought or Flood

The Federal Government established the Regional Investment Corporation in March 2018 to administer concessional farm business loans.  This began with Farm Drought loans, and in 2019 was expanded to also include AgRebuild loans for farmers affected by the North Queensland floods.

The AgRebuild loans are very tightly targeted, but eligibility for the Farm Drought loans is broader than many might expect.

On 7 November 2019 the Prime Minister announced the extension of the scheme to include eligible regional small businesses, and further interest rate concessions.j

Loans for working farmers

The loans are available owners of farms that are Australian citizens or permanent residents – although it is important to understand that the farms can be held through companies or trusts.

Not all members of a farming partnership must work on the farm, but at least one person must contribute at least 75% of their labour to the farm business under normal circumstances, and at least one partner must rely on the farm for their income – so the loans are not available for corporates.

Terms and pricing

As of 1 February 2020, the ten year loans are currently at a variable interest rate of 2.11%, with no application or other fees.

Farm Investment loans are interest only for the first five years.  AgRebuild loans are interest free for the first two years, then interest only for the next three years.  After 1 January 2020, new and existing Drought loans, and Small Business Drought Loans, will be interest free for two years.

Support of the current lender

Although the loans can be used to reduce bank debt, they can’t be used to completely replace it – normally a farmer must keep 50% of their debt with a “commercial lender.”

It’s worth highlighting that RIC will often agree to take second mortgage security.  This means that in practical terms the commercial lender’s security cover (i.e. loan-to-value ratio) can significantly improve, and so they might be quite happy about RIC becoming involved!

One other point is that even if the current lender isn’t prepared to confirm support, it may still be possible to get a conditional offer from RIC.  With a much better LVR to offer the incoming lender it may be easier for farmers to secure a refinance.

Drought loans

Drought loans are up to $2m, available to farmers across Australia, which can be used to:

  • Prepare for drought or recover from the effects of drought.
  • Pay down debt.
  • Invest in productivity or water efficiency measures.

Farmers will need to provide a copy of their drought management plan.

Flood loans (AgRebuild)

The AgRebuild loans have a much tighter eligibility criteria.  They are for farmers affected by the flooding caused by the Monsoon Trough from 25 January to 14 February 2019 North Queensland.

The AgRebuild loans are for a maximum of $5m, but rates and other terms are the same.

There are some key differences to the drought loans:

  • As noted, the loans are interest free for the first two years.
  • RIC might waive the requirement that 50% of the debt stays with a commercial lender – but only in cases of “extreme hardship,” and will be assessed on a case by case basis.
  • The loans are only available until 30 June 2020.

Small Business Drought Loans

Small Business Drought loans will provide working capital assistance of up to $500,000 for small businesses that directly provide primary production related goods and services to farm businesses in drought-affected communities.

Restrictions

There are some restrictions:

  • RIC is not a lender of last resort and will not lend unless it is satisfied that the farm or business is viable and has capacity to repay the loan.
  • RIC will require a drought management loan for drought loans.
  • As above, the ongoing involvement of a commercial lender is required, although this can be a new lender in some cases.

Summary

For eligible farmers the RIC loans can be a great option, and it is well worth checking availability.  There is a lot of useful information at www.ric.gov.au, or you can contact the author on 0404 885 062.

Disclosure of lender-imposed conditions

The 2019 Financial Reporting season has thrown up examples of very specific disclosure of the conditions imposed on listed borrowers by their lenders.

Case 1 – The amount and timing of an equity raise.

Case 2 – A requirement to conduct a ‘strategic review’ of ‘funding options.’

Case 3 – The timing and requirement for an equity raise to meet a balance sheet ratio.

Two-edged sword

Such disclosure is a two-edged sword.

Certainly, potential purchasers of the shares will be very well informed – but at the same time, the disclosure is likely to make it harder for management to achieve a turnaround. Perceived financial fragility may lead key staff to look elsewhere, and will probably make it harder for the businesses to win new business.  In some cases, it will also create liquidity problems if suppliers decide to reduce trade credit limits.*

Why is such disclosure required?

Listed companies have multiple disclosure requirements.  The Listing Rules impose a continuous disclosure regime, with limited exemptions – for example where negotiations are underway, or are confidential to another party.  The Accounting Standards also impose further disclosure requirements.

If disclosure was made to comply with the continuous disclosure regime then arguably it should have been made earlier – when the companies received notice of their lender’s requirements.

Disclosure in the Annual Report suggests that the disclosure was prompted by the auditor’s review of the financial statements – but for an outsider it is difficult to say whether it reflects a belated ‘catch up’ of continuous disclosure, or whether it is intended to ensure compliance with Accounting Standards.

Theoretical arguments about the reasons for the disclosure and whether it is strictly required may not be much help up for companies up against a deadline.  Two of the case studies had audit reports signed on the latest possible date – perhaps they simply ran out of time?

How should directors mitigate harmful disclosure?

Of course it is important that directors ensure that investors are adequately informed – but they should try to avoid do so in a way that makes it harder for the business to achieve a turnaround.

Harmful disclosure can be mitigated – but it becomes so much harder after balance date.

Businesses in turnaround mode should be projecting their compliance with covenants as part of their normal board reporting.  If non-compliance seems likely, then it is important to negotiate with lenders well ahead of any deadline.  Of course, those negotiations are far easier if supported by a well thought-out and comprehensive turnaround plan that will provide comfort that any underlying issues have been identified, and will be addressed.

* That’s also the reason why I won’t identify the companies here.

The impact of draft anti-phoenix measures on restructuring and corporate turnaround

‘Phoenixing’ – the process by which the assets of an insolvent company are transferred to another company so that creditors miss out – is a significant problem in Australia.  On budget night the government announced several headline anti-phoenix measures, with greater detail provided last week through the release of draft legislation for consultation.  Although the measures are aimed at those who act unscrupulously, they have a wider ambit, and there is the potential for them to have a broader impact if they do become law.

Overview of the measures

There is more detail here but in summary, the key concept is a ‘Creditor Defeating Disposition’ (‘CDD’).  A CDD is a transaction entered into either:

  • when the company was insolvent; or
  • in the twelve months prior to the company entering formal insolvency administration;

which prevents, hinders or significantly delays the property of a company from becoming available for the benefit of creditors.

If there is a CDD:

  • Officers whose conduct resulted in a CDD will commit an offence.
  • Those involved in ‘procuring, inciting, inducing or encouraging’ a company to engage in a CDD will commit an offence
  • Both ASIC and the Courts will have power to make orders to reverse the transaction to recover the property.

A CDD will not be voidable if the sale was for market value consideration, or was entered into by a liquidator, under a deed of company arrangement or scheme of arrangement, or as part of a Safe Harbour restructuring plan.

Market value

‘Market value’ sounds like an objective measure but in the absence of a public sale process it will be assessed retrospectively.  By comparison, the duty of care imposed upon receivers requires them to conduct an effective sale process but it does not mandate an outcome.

Safe Harbour is a defence

Specific protection for transactions entered into by liquidators and deed administrators is obvious and as expected.  A similar exemption for companies in Safe Harbour (more detail here) is a sensible and consistent policy alignment.

Application to transactions with third parties

Many would think of a phoenix transaction as a sale to a related party, but significantly it seems that the draft legislation has the potential to apply to sales to third parties, if the proceeds of sale are ‘diverted.’

The type of transaction described in an extract from hypothetical email from a CFO to a CEO highlights some of the real world issues:

We have a received an unsolicited offer for our New Zealand operations.  The offer is less than I think we would get if we took the business to market but that would take another six months, and a sale now would leave us one less headache to manage, so I recommend that we accept….

If those sales proceeds are used to pay the trade creditors of the New Zealand business, and the Australian business collapses a month later with employees unpaid, should that transaction amount to a CDD which can be reversed?  Is that email the ‘smoking gun’ which might expose directors and advisers to the transaction to the risk of prosecution?

Potential purchasers who believe a vendor to be under financial pressure may be concerned about whether they can take clear and irreversible title to business assets, or whether there may be a risk of later claw back.  Such a purchaser has a theoretical access to the general good faith defence that is available to purchasers without ‘knowledge of insolvency’, but they may need to think carefully about when exactly a suspicion about financial stress might amount to ‘knowledge of insolvency.’   Some potential acquirers may decide they need more information, or details of how the funds will be dispersed, and some may decide that it is safer to walk away and wait for a formal insolvency to deliver clear title.

Conclusion

Measures to address the serious problem of phoenixing are appropriate, and alignment with Safe Harbour measures is commendable. However, phoenixing by its very definition involves transaction with related parties. Extending the ambit of anti-phoenix measures so that they also apply to transactions with third parties risks the ability of stressed companies to promptly execute genuine sales, and should be implemented with great care.  If anti-phoenix measures need to be applied beyond those currently defined as ‘related parties,’ perhaps a better approach might be to broaden that definition.