Business owners and their advisors often spend considerable time and energy making sure that the correct structure is adopted so as to achieve maximum protection and minimum risk. But sometimes decisions made in the crucible of ongoing trading can entirely undo the benefits of correct structuring. A recent matter handled by Worrells Brisbane is a good case in point.
A well established and respected building company had developed high quality home designs, specifications and marketing systems and decided to offer these by way of franchises to other builders. The company reasoned that apart from the attractiveness of generating an additional income stream the franchise arrangement would effectively pass the trading risk inherent in any building business onto the franchisee. The company obtained advice that the franchisor should be a company separate from the building company, as that company intended to continue operations. That advice was correctly predicated on the notion that if either company failed the other could continue in operation.
Of course the director/shareholders had already taken a level of protection by opting for a company to carry on the building business. As well they had effectively protected their personal assets, including their homes, from risk by transferring them to trusts. This was done at a time when the directors were solvent and so the transfer was immune from the claw back provisions of the Bankruptcy Act.
So the structuring involved:
A company operating the ongoing building business. This recognised that the building industry is inherently risky and made sure that if that company failed there should be no effect on any other property or trading.
A separate company operated the franchise business. That company had less chance of failure but all businesses face some degree of risk, however effectively the majority of the risk had been transferred to the franchisees. As was the case with the building company the failure of this company would not impact on the financial stability of the other trading company or on the security of non-business assets.
Personal assets were held in a series of non-trading trusts. By isolating these assets in trust they would be protected even if the trading enterprises failed.
This form of arrangement is very common and effective and would be familiar to most advisors and financier, as well as to many business people.
How the Structure was undone
A. It would be no secret that the building industry has been hard by the GFC. The first manifestation of this arose when one of the franchisees failed leaving many customers with houses half built. An insurance scheme operates in Queensland to protect customers from losses in these circumstances; however it can take time for the insurance claim to be actioned. Despite the insurance scheme being in place the directors arranged for the building company to take over the jobs on the basis that this would protect the goodwill of the brand. The building company was of course reluctant to take over the building contracts and only agreed to do so when the franchise company agreed to fund any shortfall in the unpaid contract price.
The cost of taking on this work was far greater than anticipated. To help meet its funding obligations to the building company the franchise company ran up credit with its suppliers and suspended payments due to the tax office.
The franchise company has thus diluted its structuring advantage (that is passing the business risk to the franchisees) by voluntarily
taking on a franchisee’s financial responsibility.
B. Although the building company had suffered no loss from taking over the franchisee's building work (because the net costs were funded by the franchise company) it was impacted negatively by the down turn in the building industry and trade and other creditors began to blow out because of negative cash flow. This was alleviated to some extent by borrowing from the franchise company. Those borrowings were funded by the franchise company from trading income and by allowing that company’s obligation to the tax office to increase.
By lending money to the building company the franchise company negated the principal of separation inherent in the structuring. As a result the financial stability of the franchise company became tied to the fortunes of the building company, which is the very outcome which structuring was meant to avoid.
C. Despite the funding from the franchise company the building company continued to make losses. Further it could not sell its property holding at any reasonable price. It could be argued that the ongoing losses would never have been incurred if the building company had been left to pay its own way, as this would have caused it to cease trading.
Not satisfied with having put the franchise company in financial jeopardy the directors of the building company then arranged to raise funds to go into the building company, on the security of the assets held in trust. These funds were advanced to the building company on an unsecured basis
The practical effect of that was of course that assets, which were put beyond risk by transferring them to trusts in a timely way, were now at jeopardy unless the building company was able to repay the advances secured on those assets. Again, this is an outcome which the structuring was meant to avoid.
D. The building company continued to make losses and finally had to cease trading and liquidate. The net result is that the franchise company cannot recover its loans to the building company. As repayment of those loans were required to pay the debts of the franchise company that company (which was inherently profitable) also fails.
The personal assets of the directors (which were held in trust) are encumbered for non-recoverable loans to the building company and will need to be sold to repay the encumbrances.
The director’s actions in undoing the benefits of structuring were always taken for the best of intentions, and it’s only with 20/20 hindsight vision that we can discern what now seems to have been the problem in their actions and the inevitability of the final outcome.
And yet we need to pose this question: “what’s the point of structuring if clients choose to act in ways that ignore the benefits provided?”
We regularly see variations of the picture just described. It may be that professional advisors should be more forthright in advising clients to ignore structuring at their peril.