CoseNZa, Isabella --- "The Impact of Insolvency on the Recovery of Penalties" [2002] ALRCRefJl 26; (2002) 81 Australian Law Reform Commission Reform Journal 63

---

Reform Issue 81 Spring 2002

This article appeared on pages 63 – 68 & 91 of the original journal.

The impact of insolvency on the recovery of penalties

By Isabella Cosenza*

The scope of the Terms of Reference of the Australian Law Reform Commission’s (ALRC’s) inquiry into penalties is vast, referring to the ALRC the laws of the Commonwealth relating to the imposition of administrative and civil penalties. Amongst broad Terms of Reference is a very specific term that directs the ALRC to consider the effect of insolvency on a liability to pay an administrative or civil penalty.

The key issues identified by the ALRC in considering this particular term of reference are the disparity of treatment of civil and criminal penalties in personal bankruptcy and corporate insolvency schemes, and whether insolvency¹ proceedings are being misused to improperly avoid the payment of penalties imposed by courts or regulators.

Both these issues have recently received attention in other forums. The Working Group on Insolvency Law of the United Nations Commission on International Trade Law considered the treatment of fines and penalties in insolvency schemes late last year. The misuse of insolvency schemes has been addressed in legislation recently reintroduced into federal Parliament.

A major theme of the ALRC’s proposals in relation to the inquiry is the need for greater consistency – both legislative consistency in the treatment of various aspects of the imposition and recovery of civil and administrative penalties, and regulatory consistency and transparency in relation to the overall parameters within which regulators operate.

The need for consistency is pertinent to the area of insolvency. Firstly, the current law accords inconsistent treatment to the recovery of civil and criminal penalties. Generally, civil penalties are provable and criminal penalties are not, with the outcome that civil penalties will be extinguished, if unpaid, upon discharge from bankruptcy or corporate deregistration, while the liability to pay criminal penalties survives bankruptcy. Secondly, incongruous treatment is given to the recoverability of some civil penalties over others, without any apparent justification. Thirdly, individuals and corporations are treated disparately by virtue of the different outcomes flowing from bankruptcy and corporate insolvency. Finally, the lack of clarity in relation to the status of certain administrative penalties has led to inconsistent interpretations by commentators as to their recoverability.

The proposals made, and questions raised for discussion by the ALRC in its Discussion Paper Securing Compliance: Civil and Administrative Penalties in Australian Federal Regulation (DP 65) aim to impose greater legislative consistency and clarity in relation to the recoverability of penalties in personal and corporate insolvency schemes.

Background

To understand the issues explored by the ALRC, it is helpful to start by considering the different policy objectives, and the basic structuring, of personal and corporate insolvency schemes.

Personal insolvency

Personal insolvency is regulated by the Bankruptcy Act 1966 (Cth). Its major policy objective is to give a fresh start to individuals who find themselves in financial difficulties.

The basic procedural steps in the legislative bankruptcy scheme are these:

• A petition is filed in court seeking a declaration that a person is bankrupt. Either the debtor on his or her own motion, or a creditor seeking a sequestration order may present the petition.

• A sequestration order or a declaration of bankruptcy is made, at which point the property of the bankrupt vests in the trustee in bankruptcy.

• The bankrupt’s available property is realised and the trustee distributes the proceeds proportionately to those creditors who are able to prove debts in the bankruptcy, subject to a ranking of priorities.

• The bankrupt is ultimately discharged, either after three years by operation of law or earlier upon acceptance of an application by the bankrupt for early discharge.²

Corporate insolvency

Specific provisions in the Corporations Act 2001 (Cth) regulate corporate insolvency. The general policy objective of the insolvency provisions in the Act is to facilitate the orderly winding up and ultimate deregistration of insolvent corporations.

The basic procedural steps in the legislative corporate insolvency scheme are these:

• If a corporation is unable to pay its debts as and when they fall due, an application may be made to the court to wind up the company in insolvency³. The application may be made by a creditor, the corporation, a director of the corporation, the Australian Securities & Investments Commission (ASIC) or a liquidator.⁴

• While the company is being wound up, legal proceedings cannot be brought or pursued against it without the leave of the court⁵ and creditors cannot enforce against the company any judgments or orders they may have obtained.⁶

• The assets of the corporation are realised and, subject to any priority claims by creditors, the liquidator distributes the proceeds proportionately to those creditors who are able to prove debts in the corporate insolvency.⁷

• Any surplus assets of the corporation are distributed to its members on a proportional basis, subject to any provisions in the corporation’s constitution that provide for the preferential treatment of certain classes of shareholders.

• Following the winding up, the corporation is deregistered and ceases to have any legal existence. In an involuntary winding up the liquidator can apply for deregistration.⁸ In a voluntary winding up, deregistration occurs by operation of law three months after the completion of the winding up.⁹

Individuals survive insolvency. Corporations do not. These divergent outcomes affect the liability of insolvent individuals and companies in relation to the payment of penalties.

Recovery of civil penalties

The provability of a debt is linked to its recoverability. Non-criminal monetary penalties will generally be provable in bankruptcy proceedings. If not met out of the distribution of the proceeds of the bankruptcy, they are extinguished on the discharge of the bankruptcy, as with all other unpaid debts.

Section 82(1) of the Bankruptcy Act stipulates the general rule that all debts and liabilities, including future and contingent debts, to which a bankrupt was subject at the date of the bankruptcy are provable in his or her bankruptcy. Exceptions to this general rule are specified in s 82(2)-(3B) to include penalties imposed in respect of the proceeds of crime, certain civil penalties imposed under the Corporations Act 2001 and criminal penalties or fines imposed by a court.

Similarly, pecuniary civil penalties are ‘admissible to proof’ in corporate insolvency proceedings. If not met out of the distribution of the proceeds of the insolvency, they become unrecoverable following the corporation’s deregistration. Section 553 of the Corporations Act provides that in every winding up all debts payable by, and all claims against, the company which arose before the day on which the winding up commenced¹⁰ are admissible to proof against the company.

Inconsistent treatment of civil penalties

Whilst civil penalties are generally provable in bankruptcy, the law accords special treatment to certain types of civil penalties without providing any transparent justification.

An order made under s 1317G of the Corporations Act is not provable in bankruptcy.¹¹ Section 1317G allows the court to order an individual to pay a non-criminal pecuniary penalty of up to $200,000 in certain circumstances where there has been a declaration of contravention under s 1317E of the Act. Section 1317E directs the court to make a declaration of contravention if it is satisfied that a person has breached a civil penalty provision of the Act. Civil penalty provisions include provisions regulating directors’ duties, insider trading, continuous disclosure and insolvency.

The effect of the exception is that the individual’s liability to pay the penalty survives the discharge of the bankruptcy.

The rationale for the exception to the general rule was not stated in the Explanatory Memorandum to the Corporate Law Reform Bill 1992; nor is any explanation discernible from the parliamentary debates. There does not appear to be any policy reason why other civil penalties should not be treated in precisely the same manner. As addressed below, the ALRC proposes that civil penalties should not be provable in bankruptcy.

Recovery of criminal penalties

Criminal penalties are generally not provable in either bankruptcy or corporate insolvency proceedings.

Section 82(3) of the Bankruptcy Act provides that ‘penalties or fines imposed by a court in respect of an offence against a law, whether a law of the Commonwealth or not, are not provable in bankruptcy’.

Section 553B(1) of the Corporations Act similarly provides that, subject to one exception, ‘penalties or fines imposed by a court in respect of an offence against the law are not admissible to proof against an insolvent company’. Amounts payable under pecuniary penalty orders and interstate pecuniary penalty orders, as defined in the Proceeds of Crime Act 1987 (Cth), are admissible to proof against an insolvent company and are the exception to the general rule.¹²

The Proceeds of Crime Act defines a pecuniary penalty as an amount payable to the Commonwealth by way of penalty calculated by reference to ‘benefits derived by a person from the commission of an offence’.¹³

The ALRC noted in its General Insolvency Inquiry report that:

The basic policy underlying this position is that a fine is imposed for a breach of the law and should be paid in full, not simply at the proportionate rate which would apply if it ranked equally with all other debts in an insolvency.¹⁴

Michael Murray identifies additional policy aims:

The reason that severe or criminal fines or penalties are not generally provable in bankruptcy is that ordinary creditors of the bankrupt should not be prejudiced in diminution of their dividend by the criminal or quasi-criminal conduct of the bankrupt ... a bankrupt ‘survives’ bankruptcy to live on, and thus a further reason for the policy in bankruptcy is that a penalty is seen as a matter of personal responsibility that the bankrupt should retain for the sake of society’s need for retribution, compensation and deterrence, as with any criminal conduct.¹⁵

Use of the word ‘offence’ in s 82(3) of the Bankruptcy Act limits this exemption to criminal offences, affording criminal penalties under s 82(3) a special status compared to administrative and civil penalties.

In substance as opposed to form, the laws of bankruptcy and corporate insolvency treat individuals and corporations differently in relation to the recoverability of criminal penalties. The right to recover a criminal fine or penalty from an individual is unaffected by his or her bankruptcy and will survive discharge of the bankruptcy. However, insolvency proceedings lead to a company’s ultimate deregistration. Consequently, criminal penalties cannot be pursued against or paid by a corporation that has ceased to exist.

Consequences of deregistration

Should directors of an insolvent company be held personally liable for penalties outstanding against the corporation after its deregistration? The absolute removal of a company’s ability to pay monetary penalties following its deregistration increases the likelihood that regulators will commence proceedings against individual directors rather than corporations where the law allows. Deregistration of a corporation prior to a court finding that it has contravened a law does not affect the accessorial liability of persons involved in the contravention.¹⁶

A company’s inability to pay penalties following its winding up also provides an undesirable incentive for corporations liable for large monetary penalties to opt for voluntary liquidation.

Recovery of penalties imposed administratively

A broad range of penalties may be imposed administratively, either by government agencies or by automatic operation of legislation. The ability to recover an administratively imposed penalty from an insolvent entity or individual depends on it being:

• a penalty imposed by a court in respect of an offence, in which case, as discussed above, it will not be provable; or

• a civil debt, in which case it will be provable but extinguished (if unpaid) upon discharge from bankruptcy or corporate deregistration.

Commentators have divergent views as to the application of the exception in s 82(3) of the Bankruptcy Act. The area of contention is ascertaining precisely when a penalty or a fine is imposed by a court in respect of an offence.

Michael Murray considers that the liability to pay fines issued under infringement notices is provable in, and extinguished by, the bankruptcy and that fines imposed by a court, either initially or in default of payment, will not be provable and will not be extinguished.¹⁷ However, Grant Webster argues that it is important to distinguish between fines imposed by a court as a sentencing order, following a determination of guilt and an application of relevant sentencing guidelines, and fines imposed in infringement notices which are prescribed in advance by legislation.¹⁸ Webster states that the distinction between the judicial and administrative origin of the penalty is a critical determinant of its status as a ‘fine imposed by a court’ for the purposes of bankruptcy proceedings. He concludes that PERIN court fines, which are prescribed in advance by Victorian legislation, are likely to be provable in bankruptcy because they fail to meet the requirements of the exception in s 82(3) of the Bankruptcy Act. In Webster’s view, for the exception in s 82(3) to apply the fine or penalty must be imposed by a judicial body exercising judicial authority and discretion.

The penalties considered by Murray and Webster are those imposed under infringement notice schemes at state level in respect of criminal offences. The practical implications of their divergent views would appear to have less application at the federal level as infringement notice penalties under federal legislation do not take effect as a penalty imposed by a court or as a debt due to the Commonwealth. By contrast, some administrative penalties such as taxation penalties and social security overpayments and penalty interest take effect as debts due to the Commonwealth and are therefore provable in insolvency.

The status of administrative penalties should be clarified and defined with greater precision. This would resolve the inconsistent interpretations and uncertainty as to their recoverability.

ALRC’s proposals

The ALRC has formulated proposals which seek to inject greater consistency and clarity into this area of the law. It appears untenable that the state should yield all prospect of recovery of any criminal penalty imposed on a company that has later gone into liquidation, yet still pursue the notionally less severe civil pecuniary penalties, although they have no priority.

The ALRC proposes that both criminal and non-criminal penalties should be provable in corporate insolvencies so that the return to the state is maximised before the company is deregistered and all hope of recovery is lost. In 1988 the ALRC recommended in its General Insolvency Inquiry report that ‘fines imposed before or after the commencement of the winding up should be admissible in a corporate insolvency’.¹⁹ The rationale for this recommendation was expressed in the Explanatory Memorandum to the Corporate Law Reform Bill to be that ‘after the company has been wound up, there is no-one against whom the fine may be claimed and the fine is a claim by the community as a whole’.²⁰ The recommendation was not adopted due to the difficulty in justifying penalising creditors for a wrong committed by the company.²¹

The ALRC also proposes that civil and criminal penalties should not be provable in personal bankruptcies so that both will survive the bankruptcy and be recoverable, in principle, after the individual’s discharge from bankruptcy. In all cases, a regulator can exercise its discretion as to whether it seeks to recover from the insolvent party to the possible detriment of bona fide creditors, especially if it can pursue other parties.

The Working Group on Insolvency Law of the United Nations Commission on International Trade Law²² offered diverging views as to the treatment of fines and penalties. One view expressed was that there was no sound policy reason supporting the exclusion of fines and penalties in insolvency proceedings since, unless they were provable, they generally could not be collected. An opposing view was that exclusion might be justified for the purpose of increasing the assets available for unsecured creditors.

Misuse of insolvency

On 21 March 2002, the Bankruptcy Legislation Amendment Bill was reintroduced into the House of Representatives to prevent individuals from improperly using the bankruptcy process to avoid paying their debts, and to encourage individuals to consider options other than bankruptcy. The Bill was introduced into the Senate on 19 June 2002. The proposed amendments include a new discretion for official receivers to reject debtors’ petitions where it appears that the debtors can afford to pay their debts and the petition is an abuse of the bankruptcy system; removal of early discharge provisions; and confirmation of the court’s power to annul a bankruptcy that is an abuse of process.

Among those targeted by the proposed changes are high-income debtors who petition for bankruptcy with the aim of avoiding tax liabilities. The Australian Taxation Office noted in its Annual Report for 1999-2000 that some high-income earners become bankrupt for a second or third occasion with tax debts of hundreds of thousands of dollars on each occasion.

There is clearly an explicitly identified concern that insolvency may be used to avoid the payment of tax liabilities. The ALRC has not, however, identified any express concern that insolvency proceedings are being used to avoid payment of penalties. This is, however, undoubtedly implicit in the use of insolvency to avoid tax debts as overdue tax debts incur late payment penalties and interest charges.

Conclusion

Of the two key issues identified as pertinent to the Term of Reference relating to insolvency, the issue of inconsistent treatment of penalties appears to be more pressing given that legislation currently before Parliament is addressing, in part, misuse of insolvency. Disparate treatment by the law should be based on transparent and sound policy grounds. The multiple inconsistencies that presently exist in relation to the recoverability of various penalties and the treatment of insolvent individuals and corporations are difficult to sustain. In the absence of compelling policy reasons justifying incongruous treatment, consistency seems preferable.

* Isabella Cosenza is a Senior Legal Officer working on the Commission’s review of the imposition of civil and administrative penalties.

Endnotes

1. In this article, the term ‘insolvency’ is used to refer generally to the inability of legal persons, individual and corporate, to pay their debts as and when they fall due. The term ‘bankruptcy’ is used to describe personal insolvency, and ‘corporate insolvency’ is used to refer to the inability of a corporation to pay its debts.

2. Note that the Bankruptcy Legislation Amendment Bill 2002 contains a provision that will abolish early discharge from bankruptcy.

3. Corporations Act 2001 (Cth), s 459A.

4. Ibid, s 459P.

5. Ibid, s 471B and 500(2).

6. Ibid, s 468(4) and 500(1).

7. Priority payments are specified in ibid, s 556.

8. Corporations Act 2001 (Cth), s 480.

9. Ibid, s 509.

10. See ibid, s 9 for definition of ‘relevant date’ in relation to a winding up.

11. Bankruptcy Act 1966 (Cth), s 82(3AA). This section was inserted by the Corporate Law Reform Act 1992 (Cth).

12. Corporations Act 2001 (Cth), s 553B(2).

13. Proceeds of Crime Act 1987 (Cth), s 26(1).

14. Australian Law Reform Commission, General Insolvency Inquiry, ALRC 45 (1988), Canberra, para 787.

15. M Murray, ‘Fines and Penalties – Provable in Bankruptcy?’ (2000) 10(3) New Directions in Bankruptcy 13, 13-14.

16. See Australian Competition & Consumer Commission v Black on White Pty Ltd [2001] FCA 187; (2001) 110 FCR 1.

17. M Murray, ‘Bankruptcy’s Impact on “Innocent” Parties’ (2000) 10(2) New Directions in Bankruptcy 30, 30. See also n. 15, above.

18. G Webster, ‘PERIN Court Fines: Provable in Bankruptcy?’ [1998] LawIJV 209; (1998) 72(7) Law Institute Journal 53.

19. Australian Law Reform Commission, General Insolvency Inquiry, ALRC 45 (1988) Canberra, para 790.

20. Hansard, Parliamentary Debates, House of Representatives, 3 November 1992, 2404 (Mr Duffy); Explanatory Memorandum to the Corporate Law Reform Bill 1992 (Cth), 170.

21. Explanatory Memorandum to the Corporate Law Reform Bill 1992 (Cth), 170.

22. See United Nations Commission on International Trade Law – Report of the Working Group on Insolvency Law on the Work of its Twenty-Fourth Session, (New York, 23 July-3 August 2001), para 111.