RDP 2016-09: Why Do Companies Fail? 2. Institutional Background

2.1 Failures, Exits and the Corporate Life Cycle

To gain a better understanding of the corporate life cycle we analyse data on all registered companies from ASIC and the Australian Business Register. There were 2.4 million companies registered in Australia at some point during 2015. Of these registered companies, only about 36 per cent were active companies (companies that are registered to pay GST, which we take as an indication of being economically active).^[4]

It is important to recognise that estimates of average failure rates based on company-level analysis (as in this paper) will typically be higher than those based on aggregate indicators (as shown in Figure 1). This is because the company-level analysis captures only active companies, while the aggregate estimates are measured as the ratio of failures to all registered companies.

Moreover, the distinction between active and registered companies is likely to matter for the trends in the corporate failure rate. This is because there has been a trend increase in the share of inactive companies in Australia. Inactive companies face minimal insolvency risk. It follows that the aggregate measure of the failure rate may understate the ‘true’ probability of failure over recent decades.^[5]

2.2 Company Ownership Structure

As highlighted above, we evaluate the importance of ownership type as a potential determinant of failure. We identify three separate types of company ownership – publicly listed, publicly unlisted and private companies.

A public company is a company that may have an unlimited number of shareholders from which to raise capital. A listed public company is listed on a stock exchange, while an unlisted public company is not. A private company is a company whose shares may not be offered to the public for sale and which operates under legal requirements less strict than those for a public company.^[6]

For the purposes of our analysis the main differences between public and private companies are:

• Public companies are more able to raise equity from the general public and should have better access to external finance than private companies.
• Public companies have more dispersed ownership and greater separation of ownership and control than private companies, and this is particularly true for publicly listed companies.
• Public companies have greater disclosure requirements than private companies – again this difference is greatest for publicly listed companies.

On the surface, it is not clear whether these factors will imply that public companies are more or less likely to fail than private companies. For example, the greater separation of ownership and control within public companies may mean that their managers are more likely to make decisions that are in their own interest rather than in the interests of the company, leading to greater risk-taking.^[7] Conversely, the greater disclosure requirements of public companies should make them more transparent, making it harder to hide problems from creditors and therefore less likely to take risk.

To develop some testable hypotheses on how company ownership structure affects failure, we need to briefly discuss the Australian corporate insolvency system.

2.3 The Australian Corporate Restructuring and Insolvency Systems

By international standards, the Australian corporate insolvency system ranks highly in its ability to resolve company failures. In 2015, Australia ranked 13 out of nearly 190 economies in resolving corporate insolvencies based on an index developed by the World Bank.^[8]

It is not our goal to provide a detailed outline of the Australian corporate insolvency system; see Bickerdyke, Lattimore and Madge (2000) and the Productivity Commission (2015) for comprehensive overviews. Nor are we interested in examining how the insolvency system affects the overall probability of company failure. Instead, we want to briefly highlight some of the institutional features that can influence the costs and benefits of failure for different types of companies. This will allow us to develop some testable hypotheses regarding how company ownership structure affects the likelihood of failure.

Australian insolvency law is mainly governed by the Corporations Act 2001.^[9] Among other things, this legislation regulates companies that are in financial distress and are unable to pay their debts or other obligations. Australian insolvency law is designed to balance the competing interests of debtors, creditors and the wider community. The aims of the legislation include:

• providing an orderly and fair procedure for handling the financial affairs of insolvent companies
• ensuring a pari passu equal distribution of the assets among creditors
• minimising delays and costs in the resolution process
• rehabilitating financially distressed companies where viable
• engaging with stakeholders in the resolution of insolvency issues
• allowing an examination of insolvent companies, and the reasons for their failure.

Broadly speaking, the insolvency process consists of two stages. First, there is the ‘restructure’ stage; when there is hope of salvaging the company, several options exist to restructure the company so that it continues as a viable entity, including voluntary administration and informal workouts. Second, there is the ‘wind up’ stage; when a company is irretrievably insolvent and unlikely to recover, several processes can be used to wind up the company, including various forms of liquidation and receivership.^[10]

More importantly for our purposes, the potential benefits and costs of the Australian insolvency system are likely to vary with the characteristics of each company, such as the ownership structure and size of the company.

For instance, at the ‘restructure’ stage, a company can enter into an informal workout. These workouts are private agreements between the company and its creditors, with no involvement of outside parties. This reduces the chance that the company's reputation will be affected by the stigma of entering external administration. Public companies are typically more transparent than private companies in their financial reporting. Importantly, the higher degree of transparency at public companies, and particularly publicly listed companies, may hinder the process of corporate restructure via informal workouts and hence increase the probability of failure; the requirement to keep the market informed can undermine sensitive deals and thwart attempts at restructure, leading to higher rates of insolvency, on average (Productivity Commission 2015).

The threat of insolvent trading may also encourage company directors to seek the protection of voluntary administration rather than try to restructure the company. This is because, under current insolvency laws, company directors are exposed to potential civil liability if they incur any additional debt when the company is already insolvent (or becomes insolvent because of the additional debt). For directors, the threat of personal liability can outweigh any potential benefits from attempting to continue the business. As a result, directors may claim insolvency even when the company is only experiencing temporary financial distress and, in fact, has good long-term growth prospects.

The potential personal liabilities are likely to be greater for directors with ‘more visible’ reputations to uphold. To the extent that the owners of public companies are more visible to the general public than that of private companies, it might be expected that public companies have a greater incentive to voluntarily choose to enter administration rather than informally restructure the company. A similar dynamic could make directors of publicly listed companies more likely to opt for external administration than directors of publicly unlisted companies.

This allows us to develop two testable hypotheses:

• H1: Public companies should have a higher rate of failure than comparable private companies, on average.
• H2: Within public companies, listed companies should have particularly high rates of failure, on average.

Footnotes

Many inactive companies are superannuation trustee companies for self-managed superannuation funds. Other inactive companies are likely to be mainly used for holding assets and providing tax and liability benefits. [4]

This is not a problem for our company-level analysis, as it captures only active companies. [5]

See La Cava and Windsor (2016) for more details. [6]

Public companies may also be more likely to have diversified shareholders than private companies, which encourages them to take more risk (García-Kuhnert, Marchica and Mura 2015; Faccio, Marchica and Mura 2011). [7]

The main criterion for determining the ranking is the ‘recovery rate’, which calculates how many cents on the dollar secured creditors recover from an insolvent company at the end of insolvency proceedings. In Australia, creditors are estimated to recover about 82 cents in the dollar compared to an OECD average of around 72 cents. [8]

Under Australian law, the term ‘insolvency’ is usually used with reference to companies, and ‘bankruptcy’ is used in relation to individuals. [9]

There are several steps to be taken for a business to be closed. These include finalising tax obligations, fulfilling obligations to employees and suppliers and cancelling or transferring any business registrations. The process of deregistration is complicated for companies that have complex operations or ownership structures. In particular, dealing with employee requirements under the Fair Work Act 2009 is often complex and time consuming (Productivity Commission 2015). As a result, the process of winding up a company can often take years to complete. [10]