'Insolvency'

James Thomson | smartcompany.com.au

A record spike in the level of bad debts held by Australia’s banks means their harsh treatment of business customers is far from over, a business restructuring expert has warned.

Cliff Sanderson, managing director of business consultancy Restructuring Works, says figures released late last week shows the level of bad debts held by Australia’s banks soared to $33.1 billion for the nine months to September 30, compared to an average annual rate of $4.4 billion between 1995 and 2008.

Sanderson says bad debt charges increased by around $7 billion in the September quarter, down from $10 billion in the June quarter of 2009.

“It’s another thumping number,” Sanderson says.

“I had expected material reductions in the last two quarters, particularly because insolvency figures just haven’t been rising as quickly as we thought. But these are huge numbers compared to the last decade.”

Sanderson thinks the high numbers bad debt are a result of the banks being conservative, but they also underline the fact that small and medium size businesses tend to be last into a downturn and last to emerge into the recovery.

He points out that insolvency figures after Australia’s last recession, which started in 1987, didn’t peak until 1991-92.

“History would say it takes a long time to filter through and that’s because if directors of small companies think that if there’s a chance of surviving, they’ll take it.”

Sanderson’s data also dispels any notion that banks may have tried to nurse struggling companies through the very worst of the downturn.

Banks took possession of 1,342 companies or assets in the 11 months to November 2009, which Sanderson says is almost triple the average of 523 from the previous five years.

But not all of these cases ended with the company or asset being put into the hands of a receiver. The number of “in-house” appointments by banks increased five-fold to 505 in the year to November, indicating a strong preference for banks to closely manage their own bad debts.

“There seems to have been this view that the banks have been nice – they haven’t,” Sanderson says.

And that trend is almost certain to continue. Sanderson expects banks will remain extremely aggressive about recovering debts and rising asset prices could give them the confidence to move in on a company and sell if it necessary.

“If the economy continues to recover, they will continue to recover their debts,” Sanderson says.

“I expect they’ll target that bottom 15% that is really struggling. If the rest of the world continues to improve, you can be tougher on the bottom ones. “

In contrast to the hard line taken by the banks, Sanderson says the ATO remains very sympathetic to struggling companies.

However, there are some signs the taxman’s generosity is coming to an end.

“We started to see a couple of the director penalty notices in November and December and I hadn’t seen any for the last six months. As soon as they start serving those, it invariably leads to appointments.”

Chartered Secretaries Australia | Cliff Sanderson | April 09 Vol. 61 No. 3

All of us have some idea about the level of corporate distress at the moment, right? Let’s trot out a couple of pieces of accepted wisdom:

“The number of companies going broke is through the roof”
“Banks don’t appoint Receivers as often anymore”
“If you want to save a company that’s in financial trouble the way to go is a Voluntary Administration”

All wrong. And don’t start getting complacent because some other truly worrying facts are emerging.

Some truths and some myths

Restructuring Works has recently produced the Business Stress Report. Some of the findings did reinforce what we would expect in the current economic crisis but there were also some myths exposed:

• Myth 1 – The number of insolvencies is way up!
The number of companies entering some form of insolvency administration in the year ended December 2008 has increased 27% when compared to the average of the previous 5 years (Graph 1). So the number of corporate insolvencies is up but they are not through-the-roof. Well, not yet.

• Myth 2 – Banks don’t appoint Receivers as often as they used to!
The number of appointments by secured creditors, most commonly receiverships, is up a massive 105% on the average of the previous five years (Graph 2). That is a surprise. We have heard for a while that banks are stepping back and encouraging directors to sort out their company’s problems themselves. Well the statistic show that banks may not like appointing receivers, but they are doing it twice as often as they used to!

• Myth 3 – To save a company, appoint a Voluntary Administrator!
The percentage of companies successfully restructuring is very low and trending lower. Only 27% of companies that enter Voluntary Administration successfully agreed a Deed of Company Arrangement (”DOCA”) with their creditors in 2008. Remember that Voluntary Administrations is the bit of the insolvency legislation that is supposed to save a company. Well that’s not happening very often.
If the number of companies going broke is not too bad, does this mean we have been worrying unnecessarily? Afraid not. We should worry as some frightening realities did emerge. Even though the number of companies going broke is up a bit, the value of those insolvencies is up a staggering amount. We measure this by looking at Bank New Asset Impairment Charges. The value of those bad debts in our banks has more than tripled to $13.3 billion in the year to September 2008 compared to an average $3.7 billion for the previous five years (Graph 3).

Feeling scared yet? If not here is some more. Corporate Australia is twice as indebted as it was just five years ago and Australian households are close to twice as indebted as they were just ten years ago.

So the quick summary – companies are twice as indebted as they were just 5 years ago, more companies are in financial distress, the companies going broke are the big ones and yet the success rate for companies successful restructuring is very low and getting lower.
Some (not so) brave predictions

We have already started to see many major companies in either informal workouts or formal insolvency appointments. The pileup at the big end of town is a reality. So where is it heading?

Let’s look at the last major stock market correction back in October 1987. The wave of large corporate insolvencies didn’t begin until late 1988 and early 1989 with the likes of Bond Corp, Quintex, Equiticorp and Spedley. It didn’t hit the real economy until 1990 through to 1993 when the bad debt figures in the banks went through the roof and specialist insolvency firms quadrupled in size. Early 2009 has seen the start of the flow on effect to medium and small enterprises.

Our conclusion is that the number of corporate insolvencies is set to skyrocket in 2009 and 2010.

Key Lessons from the Research

The low success rate in company restructurings is a real concern. There are some reasons for it.

Firstly, the success rate has never been high. The Australian system removes power from the directors and shareholders and places control in the hands of an independent expert, the insolvency practitioner, and the creditors. Other insolvency regimes, such as Chapter 11 in the US, leave control in the hands of the existing directors who are supervised by the Courts. This gives additional negotiating power to the company and its directors to force through a deal.

Secondly, directors have learnt over the years that companies rarely survive a formal insolvency appointment. Hence they are reluctant to make an appointment of an external expert which leads to the self-fulfilling situation that when they do appoint an external expert it is often too late to save the company.

It is unlikely that any meaningful changes will be made to insolvency laws in the immediate future and yet many companies will become financially distressed during 2009 as a result of the global economic crisis. So what does a director do?

There are a wide variety of tried and tested techniques that can be used to save a company. We’ve successfully restructured many companies in Australia and internationally during the last 20 years. Our basic philosophy is to use the “Least Drastic” restructuring methodology. We use the term Restructuring Spectrum to describe the various situations a company may face and when a company’s financial position is established we can then identify the corresponding “Least Drastic” solution.

One thing is for sure – there will be lot of companies in financial distress in 2009 and directors of those companies should seek advice from a restructuring professional.