Insolvent Builders & Home Warranty Insurance (“HWI”)

For many individuals or couples one of the biggest purchases in their lives will be the construction of a new home. Unfortunately over the years there have been many residential home builders that have gone into some form of insolvency administration and ceased to trade, leaving home owners with an incomplete home and lots of worries.
We are frequently appointed as Voluntary Administrators or Liquidators to residential home builders where they are insolvent. In one recent matter, there has been an instance where the HWI policies were not adequate to cover all costs incurred in completing the homes. We highlight in this article some important considerations customers should give if such an event occurs.

HWI is taken out by the residential home builder and is designed to cover customers. From 1 July 2010, the NSW Self Insurance Corporation, trading as the NSW Home Warranty Insurance Fund, took over as the sole provider of home warranty insurance in NSW. QBE Insurance (Australia) Limited and Calliden Insurance Limited were appointed as insurance agents of the NSW Self Insurance Corporation, through a contractual arrangement.

Importantly HWI provides a set period of cover for loss caused by defective or incomplete work in the event of the death, disappearance or insolvency of the residential home builder.

From 1 July 2002 a key element of a HWI policy is that it must indemnify beneficiaries (i.e. the customer) for non-completion of work due to early termination of the building contract. Insolvency of the residential home builder typically results in the termination of the building contract.

Critically from 1 February 2012, a HWI policy:

  • is required to be obtained where the contract price is over $20,000 or, if the contract price is not known, the reasonable market cost of the labour and materials involve is over $20,000; and
  • must provide cover of at least $340,000.

Relevantly claims for incomplete work are limited to 20% of the contract price (up to a maximum of the cover provided under the policy). It is this aspect that we believe is not always well understood by customers and indeed the residential home builder when insolvency occurs. We have set out below a recent matter we were appointed to highlight how HWI works when an insolvency event occurs resulting in the termination of the building contract.

Facts

  • Contract value for construction of home $300,000;
  • Costs paid as at insolvency event by home owner for first stages of construction $100,000;
  • Invoice issued by residential home builder for work completed but unpaid $25,000; and
  • Balance outstanding under contract at time of insolvency event / Liquidation: $200,000.

At the date of insolvency, the Insolvency Practitioner is often provided with a debtors listing relating to progress claims made by the residential builder. The recovery of each debtor is not always straight-forward and an accurate position regarding what the customer may owe (if any) can only be determined once the HWI is finalised. This can take many months to determine.

Given the above facts, the HWI and customer position unfolded as follows:

  • Following the liquidation of the residential builder, the customer lodged a claim under the HWI policy.
  • The Home Warranty Insurer arranged for an external consultant to inspect the dwelling to confirm / quantify the amount of works required to complete the contract.
  • The customer also had to prove to the Home Warranty Insurer the quantum of payments made to the residential home builder under the contract. In this case no “cash” payments had been made, but in circumstances where this occurs, this can create issues.
  • Three (3) quotes were obtained from different builders to complete the works. The Home Warranty Insurer then approved one of the builders to complete the works.
  • The certified costs to complete the dwelling were $250,000. Therefore, the customer paid the balance of the original contract price being $200,000 and made a claim for the additional $50,000 under the HWI policy.
  • In this case as the additional cost to complete the dwelling was less than 20% of the original contract price, the HWI covered the additional $50,000 that was required to complete the construction of the dwelling. Therefore there were no monies collectible under the outstanding progress claim in the Liquidation.
  • HOWEVER, if the certified costs had been for example, $285,000 (thus meaning the additional costs were greater than 20% of the contract price), then the customer would have had an uninsured loss to the extent of $25,000 that would have to be met from their own funds. In the particular insolvency administration concerned, there were 3 customers who ultimately had uninsured losses ranging from $25,000 to $60,000 per customer. Not insignificant!!

Unfortunately when an insolvency of a residential home builder occurs, it may take several months to work through this process and it will only be at the conclusion of the building contract once all of the costs are known, that the Liquidator would be in a position to determine if there is actually any debt owning by the customer.

It is important that customers get the right advice as to their position when their builder has been placed into some form of insolvency administration. We caution customers who want to go off miss-informed and complete the dwelling themselves as once this occurs they are likely to jeopardise any ability to claim on HWI.

 

Personal Insolvency – A Potted Summary

Personal Insolvency – A Potted Summary
Introduction

In Australia the Personal Insolvency regime is governed by the Bankruptcy Act 1966.  This is a Federal Act of Parliament and contrary to popular mythology the aim of bankruptcy is not to blame or punishes insolvent debtors but to afford them a process by which they can become financially rehabilitated.  A secondary aim is to ensure that creditors receive a fair distribution of the available assets and finally, that so far as the community is concerned; justice is seen to be done.

Like all acts of parliament, the Bankruptcy Act is divided into a number of parts

Overall Structure

Part IV is the main operational part of bankruptcy.  Alternatives to bankruptcy are found in Part X and these are known as Personal Insolvency Arrangements.  Debtors who have relatively small debts can use Part IX; however the financial limits are restrictive.  In very rare cases the Bankruptcy Act also has provisions dealing with insolvency deceased estates and these are found in Part XI.

Debtors Petition

The most widely used area of the Bankruptcy Act is in fact IV and most bankruptcies are voluntary.    These are known as Debtor Petitions.  A debtor who finds himself/herself in a hopeless financial situation is able to complete various forms and file these documents with the Insolvency Trustee Services Australia (ITSA).  Once the documents are filed and accepted, the individual is bankrupt and a bankruptcy number and a certificate of bankruptcy issued.  This is a relatively easy process, although some debtors may need assistance in completing the Statement of Affairs. It is important that this form must be completed carefully as ITSA is in the habit to rejecting forms even if minor details are omitted.

Creditors Petition

Whilst the process of becoming bankrupt on a voluntary basis (debtors petition) is inexpensive and quick, the opposite is true for creditors who are trying to force a debtor into bankruptcy. (Creditors Petition). The process is drawn out and expensive and creditors and their legal representatives are required to take great care in the way in which their application is made.  The Courts appear to be quite lenient towards the debtor, particularly in relation to requests to grant adjournments.

The process usually starts with the creditor obtaining a judgement debt against the individual.  Following the successful judgement, the creditor issues a Bankruptcy notices requiring the debtor to pay the debt within twenty one days.   Failure to comply with the bankruptcy notice is an act of bankruptcy as defined in the Act and the primary evidence required for the Creditor Petition.  Once the twenty one days has expired, the creditor is able to make an application to the Court for a Sequestration Order and in this process, the creditor can obtain Consent to Act from a Trustee whose job is to administer the bankrupt estate.

Consequences of Bankruptcy

Irrespective of how the individual becomes bankrupt, the consequences are virtually the same.  All property owned by the bankrupt, defined as divisible property vests in the Trustee for realisation and distribution to the creditors.  This property not only includes all the property presently owned by the bankrupt but any property the bankrupt acquires in the future, that is during the period of the bankruptcy, which is usually three years.  The definition of property also extends to property once owned by the bankrupt, but now divested.  The Act gives the Trustee power to undo certain transactions usually designed to defeat the creditors.  In this regard, certain transactions can be reversed within a six month period, others go back two years and yet others go back five years depending on the nature of the transaction.  In general, these “antecedent transaction” rules are designed to ensure that all the creditors get a fair distribution and no particular creditor is favoured over other creditors, and that the bankrupts are not seeking to hide property that would otherwise be available to their creditors.

Protected Property

Certain property is of course specifically protected under the Bankruptcy Act.  Necessary household property, a motor vehicle, tools of trade and superannuation are examples of protected property.  There are financial limits on these items.

Income Contributions

Another consequence of bankruptcy is that during the period of the bankruptcy, the bankrupt’s income is monitored and if the bankrupt’s income exceeds the threshold, he or she is required to make a contribution. These contributions are based on a statutory formula which broadly is 50% of the bankrupt’s income above and beyond the threshold and after income tax.  There are a number of other issues that are taken into account in calculating the Income Contributions.

In most cases the income contribution regime is not particularly onerous for individuals and of course is limited to the period of the bankruptcy.

Overseas Travel

A bankrupt needs permission from the Trustee to travel overseas. Permission should not be unreasonable withheld.  A “request to travel overseas” should be made in accordance with the guidelines.

Superannuation

Superannuation is protected property, that is to say that superannuation benefits are not normally available to the Trustee for distribution to creditors.  A problem however does occur when a bankrupt has a self-managed superannuation fund.  Superannuation rules prevent the bankrupt being the trustee of a Superfund and the Corporations Act prevents the bankrupt from being a company director, thus ruling out the bankrupt’s ability to be a director of a trustee company.  This unfortunately leaves a bankrupt really only three options.  1 if eligible, wind up the Superfund, 2 roll the fund into a retail or industry fund or, 3 appoint a new trustee known an RSE a Registered Superannuation Entity.

Discharge

Discharge from bankruptcy is normally automatic however, a trustee can object to the discharge in certain circumstances, although it is important to note that reasons must be given.  The bankrupt of course has various appeal provisions in relation to these objections.

Annulment

Conversely, a bankrupt can obtain an early annulment from bankruptcy.  Annulments can be obtained if a bankrupt either pays all creditors in full, or pursuant to Section 73 is able to be obtain the consent of creditors for a composition or a scheme of arrangement.  In practice, the Section 73 arrangements are extremely useful, primarily because there is little creditor resistance.

Tax Consequences

In general any tax debt owed by the bankrupt is treated in the same way as all of the other unsecured creditors.  That is to say the Australian Taxation Office (ATO) simply lodges a Proof of Debt with the trustee and receives a dividend as an ordinary unsecured creditor.  In addition, as with all of the unsecured creditors, the bankrupt is released from this on discharge from bankruptcy.  A small complication does occur in relation to income tax in that the amount provable relates only to the income generated by the bankrupt up until the date of the bankruptcy.  Income generated after this date is not a provable debt and the bankrupt’s obligations to pay income tax on this income continues.  This necessitates the lodgement of two income tax returns for the relevant period.  One up to the date of the bankruptcy and the next one from that date to the 30th June of that year.

Capital Gains Tax

A property sold by the Trustee; may trigger a Capital Gains Tax Event.  As this event occurs after the date of bankruptcy, it is not a provable debt.  The Courts have held that it is not a cost of the administration and therefore the debt becomes a new debt of the bankrupt.  This is an inelegant result and the only practical solution is for the debtor to file a second and subsequent petition as soon as the debt becomes provable.

P.I.A.

There are alternatives to bankruptcy and these are found in Part X of the Bankruptcy Act.  These alternatives are known as Personal Insolvency Arrangements.  These arrangements are no longer as popular or as useful as they once were having regard to significant legislative amendments that took place in the early 1990’s.  In addition because the arrangements require the creditors to vote in favour of a debtor’s proposal, they are becoming increasingly difficult to have approved primarily because of creditor resistance.  As indicated earlier, this resistance does not appear as evident when similar proposals are being put pursuant to Section 73.  In addition the cost of the Personal Insolvency Arrangement in many cases make them prohibitive for most debtors and having regard to the fact that the Personal Insolvency Arrangements still appears on the National Personal Insolvency Index (NPII), and other credit rating agencies there is little incentive for debtors to embark on this course of action.  In special circumstances however, they are still worth considering.

 

ATO – Insolvency and the Tax Man Jekyll & Hyde

The title of this paper is named after the character created by Robert Louis Stevenson commonly known today as “The strange case of Dr Jekyll and Mr Hyde”.  The Jekyll and Hyde description usually refers to a person with a split personality, one good and one bad.  So it is that in many cases the Australian Taxation Office (The ATO) seems to have a Jekyll and Hyde approach when it comes to tax payers who are unable to pay their debts due to insolvency.
WHY IS THE ATO THE CENTRE OF ATTENTION

When businesses get into financial difficulty, cash flow becomes extremely tight.  The simple principle is that the noisy cog gets the oil, thus employees are paid before critical suppliers, critical suppliers are usually paid before the landlord, and the landlord is usually paid before the ATO or any other statutory obligations.

In effect, and as a result of the somewhat slow response that the ATO has to its recovery policies, it effectively becomes a tacit funder of businesses that are failing.  In certain industries, it is almost an industry paradigm that the ATO is used instead of a bank overdraft.  Of course the net effect of this is that the ATO has been criticised for funding businesses or business operators that should not be in business.

The apparent inertia of the ATO in its debt recovery program seems to have the effect of lulling business operators who have outstanding tax debts into a false sense of security.  At least initially.  It appears that, prior to the ATO commencing legal proceedings it has historically been quite open to coming to sensible payment arrangements with business operators in relation to reduction of debt.  In fact during the height of the global financial crisis the ATO had demonstrated some considerable tolerance and was entering into remarkably easy repayment plans. Dr Jekyll, if you like.

This position has clearly changed and moreover it appears that the ATO has increased its activity in relation to legal proceedings. Furthermore, it appears that once the ATO has commenced legal proceedings, its ability to negotiate payment plans and concessions seems to disappear.  Mr Hyde has emerged.

The action that the ATO takes in relation to debt recovery depends on whether business is operated as a company or as a partnership or sole trader.  I will deal with the situation affecting individuals first.

ATO ACTION AGAINST INDIVIDUALS

It must first be remembered that the ATO, except for superannuation guarantee charge is an ordinary unsecured creditor when it comes to debt recovery proceedings and as such it has legal rights pertaining to an ordinary unsecured creditor only.  This means that in most cases, the only viable action the ATO can take against individuals is to proceed with a judgement against the individual and then in order to enforce the judgement proceed to what is referred to as a Creditor’s Petition and Sequestration Order.  This means the ATO will be seeking to make the individual bankrupt.  Of course as with any other unsecured creditor, the ATO also has the option of serving a Writ of Execution on the debtor’s property or obtaining a garnishee order against wages or salary.

It is important to note that at any time prior to the granting of the Sequestration Order individuals can step in and take control over their own affairs.

HOW DO INDIVIDUALS TAKE CONTROL?

An individual can either file his or her own Bankruptcy/Debtor’s Petition or appoint a Controlling Trustee with a view to entering into a Personal Insolvency Agreement (P.I.A.).  There is an advantage for the debtor in doing this as he or she can choose the time of commencement of the Bankruptcy or P.I.A. and has the opportunity of appointing his or her own Bankruptcy or Controlling Trustee.  No matter how aggressive the ATO has been in pursuing an individual, once a Debtor’s Petition has been filed all action is stopped and the file is effectively closed.  Mr Hyde now becomes Dr Jekyll.

If the debtor wishes to enter into the P.I.A. a creditors meeting is convened by registered bankruptcy trustee pursuant to Section 188 of the Bankruptcy Act 1966 and a special resolution of creditors is required.  This means that 75% of the value and a majority in a number of creditors who attend the meeting are required to approve the proposal.  Of course if the ATO is a major or dominant creditor it is difficult to obtain a yes vote so Mr Hyde has once again returned.

As an alternative to a P.I.A. experience indicates that Section 73 of the Bankruptcy Act is far more effective.  In short Section 73 applies to an individual who is already bankrupt.  The Act provides that a person in this circumstance can simply request his or her trustee to convene a creditors meeting for the purpose of putting a proposal to the creditors for an arrangement or a composition. The voting requirement is the same as for a P.I.A. that is a special resolution.  However, experience indicates that creditors including the ATO are far more receptive to supporting a proposal under Section 73 than a similar proposal under the provisions found in Part X.  Dr Jekyll is back.

There are a number of reasons for this.  The first is that creditors are far less suspicious of a debtor who is already bankrupt proposing an annulment of the bankruptcy than an individual who is not yet bankrupt but trying to avoid the same.  The second is, once an individual has become bankrupt most creditors seem to write off the debt or alternatively the file is passed to a different department.  Furthermore experience demonstrates that meetings convened under the Section 73 attendances can be poor to non existent and this has the added advantage of removing the anxiety and stress from the individuals who are making the proposal.  This is an important consideration for professionals advising debtors as the emotional state of clients is very important.

ATO ACTION AGAINST COMPANIES

Where the ATO is pursuing a company, the process is slightly different.  Again it must be remembered that the ATO is merely an unsecured creditor (except for S.G.C) and it cannot appoint a Receiver or an Administrator.  The ATO must proceed as with any other unsecured creditor in obtaining a judgement, issuing a statutory demand and then commencing winding up proceedings.

It is important to note and this is somewhat different to the position in bankruptcy that once the ATO has commenced formal winding up proceedings, it is not possible for the directors of the company to commence the Voluntary Liquidation of the company.   The only option available to directors in these circumstances is to appoint an Administrator.

Furthermore, this is not without its complications.  It must be remembered that once the ATO has commenced winding up proceedings a hearing date has been set. An Administrator will need to have the winding up hearing adjourned to enable him to complete the normal investigations, Report to Creditors and convene the requisite meeting to consider the company’s future.  In most cases the Court will grant an initial adjournment providing the Administrator gives certain undertakings in relation to not holding the decision meeting of creditors without first referring to the Court.

Once the Court does provide the initial adjournment, the Administrator’s task is to prepare a report to the creditors and to submit the director’s proposal for consideration.  Clearly the proposal will need to provide a better outcome to creditors than the winding up. The matter usually then goes back before the Court for considering a further adjournment to enable the creditor’s meeting to be held and this adjournment is not automatic.  Frequently the ATO opposes the adjournment and often the reason given is not commercial but that the company should be wound up “in the public interest”.  Issues such as the taxpayer’s compliance history and the extent to which public funds have been used to support the failing company’s business are often put forward as reasons for discontinuing the operation of the business.  It looks like Mr Hyde is back. In most cases the Court takes an objective view of this and looks for evidence that there are other creditors whose interests need to be served, thus justifying the need to proceed.

If the Court grants the second adjournment the creditors meeting can proceed and the outcome and future of the company will then depend on the resolution of creditors.  It is important to note that this vote will simply be on a bare majority number and value (a poll) and if the numbers and the values disagree, the chairman has a casting vote.  It should be obvious that once it gets to a creditors meeting stage it is far easier for a company to enter into a Deed of Company Arrangement than the counter part in the bankruptcy jurisdiction in relation to a Personal Insolvency Agreement which of course requires a special resolution for acceptance.

Again as a matter of experience even if the ATO votes against the proposal, providing the other creditors are sufficient to out vote the ATO, it is unusual for the Court to grant a winding up Order unless there are some extenuating circumstances. This could be if the resolution was passed due to related entity claims.

EARLY ACTION IS GOOD

If the company goes into Administration before the ATO commences legal action the situation is totally different.  Clearly there is no Court involvement and the matter will be dealt with at a creditors meeting by a simple vote (a poll).  In most cases the ATO will be out voted and must acquiesce unless there are unusual circumstances.  As a consequence, the attitude of the ATO again returns to that of the good Dr Jekyll.

OTHER REMEDIES AVAILABLE TO THE ATO IN RELATION TO COMPANIES

The ATO has the capacity to issue a Director Penalty Notice in relation to outstanding PAYE Group Tax deductions.  This notice is sent to the Director’s home address and it gives the directors 21 days to comply.  Compliance means the company either, pays the debt, make arrangements to pay the debt, goes into liquidation, or appoint an Administrator.  Default means that the director or directors will be personally liable for the outstanding debt and the ATO can then commence personal bankruptcy proceedings against the directors.  It is important to note that this notice is not sent to the company’s registered office, nor is it sent to the company’s tax agent and as a result it is often overlooked and by default expires.

The notice itself is somewhat bland and certainly less intimidating than much of the other correspondence being received by directors whose companies are facing financial difficulty.  This is another reason why the notices are often overlooked.

Another tactic the ATO can use against companies is to serve a Garnishee Notice on the company’s debtors or bank accounts pursuant to Section 260-5 of the Taxation Administration Act.  If this tactic is used it can be somewhat fatal to the company’s operation as it has the effect of cutting off the company’s cash flow.  This can happen to a company at any time and without notice and the company director should therefore be aware of the potential of this axe falling at any time.

Clearly the conclusion again that should be reached in relation to all of the above matters is that if a company is facing financial difficulties it is far better to act earlier than later.

ANTI FRAUDULENT PHOENIX LEGISLATION

The Government announced in the 2011 budget that it would expand the current director penalty notice regime to include superannuation guarantee amounts and to deny directors the benefit of PAYG credits when such payments are not remitted to the government or to the ATO.  Most importantly the new legislation denies the 21 days grace period where there is unreported debt exceeding 3 months.

This legislation is purportedly aimed at preventing fraudulent Phoenix activity whereby directors purposely use a succession of companies in a cyclic manner specifically to avoid statutory debts.

The legislation has been criticised on a number of levels.  Firstly, it has been submitted that the ATO has already significant debt recovery tools which it currently under utilises.  Secondly, the fact that the ATO is so tardy in relation to its debt collection proceedings will not be solved by the new legislations.  This is an administrative issue not a legislative one.  Thirdly, it is quite clear that the directors would not take positive steps unless they are forced to and in the absence of serving directly penalty notices it is unlikely that the directors or failing companies will take any action whatsoever.

The fifth issue is that the broader economic concerns will not be addressed by this legislation and may get worse. If the ATO relies on the new legislation and “cherry picks” directors it wants to pursue rather than address the administrative issues the net effect will be inefficient business will continue to be propped up.  This has significant impact on the competitive environment in particular it allows inefficient businesses to unfairly compete with legitimate and honest businesses that are paying all their taxes as and when they fall due.

Finally and most importantly, there is no mention in the Legislation of “Fraudulent Phoenix Activity” and many commentators believe that the Legislation whilst intended to attack such activity misses the mark entirely and simply allows the ATO to cherry pick those directors it intends to pursue.

We have submitted that the legislation by and large is well intended and conceptionaly sound, but we have suggested amending the legislation such that grace period be deleted where there is an unreported debt of 3 months and the directors have been an officer of a previous failed company within the last 5 years OR the ATO can prove that there is a “Fraudulent Phoenix Activity”. (to be defined)

We further believe that notwithstanding the fact that no notification is required, there is sound public interest issues involved with the ATO serving some sort of warning notification as the business community generally is unaware of the ramifications and most directors will not take action unless some critical issue occurs.

Importantly the legislation should not replace more rigid administrative procedures in relation to debt recovery.

We believe that without the amendments suggested, that many innocent directors will be caught by the legislation, the community will not be well informed and not served by this legislation and that struggling businesses will continue to be propped up by the ATO as there is no clear evidence that the ATO will use its new tools any more aggressively than the tools it currently has.

CONCLUSION

In a subtle way the Jekyll and Hyde theme continues because it is the lack of action by the ATO in regard to debt recovery that causes most of the harm to the business environment.  This is so firstly because it creates a false sense of security to poor performing businesses and secondly by effectively propping up such inefficient businesses it adds unfair competitive pressures to compliant tax payers.