Jones Partner

Beware of Zombie Companies Post Covid-19

21/05/2020 by Bruce Gleeson

By Bruce Gleeson, FCA FCPA RITF

Director – Jones Partners Insolvency & Business Recovery

The proliferation of zombie companies pre Covid-19 has largely been fuelled by reduced financial pressure. Examples being financial institutions continuing to offer (or not otherwise call in) finance to non-viable companies and also the impact of lower interest rates particularly post the global financial crisis (“GFC”). During the Covid-19 pandemic these zombie companies have been allowed to gather further momentum and the damage that this is likely to cause post Covid-19 presents a real and present danger for those that are transacting with them.

What is a zombie company?

Wikipedia describes them as “companies that are indebted businesses that, although generating cash, after covering running and fixed costs they only have enough funds to service the interest on their loans, but not the debt itself. As such they generally depend on banks (creditors) for their continued existence, effectively putting them on never-ending life support”.

For the history buffs!

The phrase “zombie company” was initially used when Japanese businesses were supported by Japanese banks from around 1991 during the period known as the lost decade. It regained traction during and post the GFC when American businesses received bailouts from the Government. Then in 2016, when the Chinese equities market crashed, the Government moved to address the zombie company problem by closing them down or re-organising their financial affairs.

Further momentum during Covid-19

Given the multiple and significant stimulus packages offered by the Federal and State Governments and the stance of the banks/financial institutions during this pandemic, zombie companies will be allowed to continue walking dead and incur further debts. One merely needs to consider some of the following measures (which is not exhaustive):

  • the decision to reduce the cash rate to 0.25% and a program of quantitative easing commenced by the Reserve Bank;
  • relaxation of debt recovery processes – extended from 21 days to 6 months;
  • the 6 month hiatus on insolvent trading;
  • the rent relief guidelines during Covid-19;
  • the JobKeeper program;
  • the deferral of loan repayments offered by bank and financial institutions; and
  • the passive stance of the Australian Taxation Office (“ATO”) to recover tax debts

to know that there are going to be zombie companies that will rack up more debts during this period. This will make the ultimate insolvency event bigger and therefore having a more detrimental impact on those that supply or are otherwise connected with them.

Research into zombie companies confirms that they weaken economic growth. In particular, they tend to be less productive and crowd out growth of more productive businesses by locking resources. This congestion effect acts as a handbrake on industries that these zombie companies operate within.

Economic Growth and Post Covid-19

Whilst it may sound harsh, a key feature of any insolvency process is to enable economic efficiency. What we need coming out of this pandemic is to have a focus on economic growth.

Essentially where a distressed company has no realistic prospect of trading profitably into the future, appropriately and empathetically terminating its existence enables capital to be recycled and reinvested in other ventures. Such recycling is essential to ensure long-term productivity and economic growth in an economy. If capital is otherwise left in loss making zombie companies, the economy will stagnate.

As has often been remarked during this pandemic:

  • it is unprecedented; and
  • the economic impacts will likely be greater than the health impacts.

Importantly the above acknowledges that there are some families that have lost loved ones during this pandemic and they are still dealing with such loss.

But now more than ever as we look to recovering economically from Covid-19, we need to consider that saving all companies, particularly when they are not viable and were in financial difficulty well before Covid-19 is not a good thing.

There is no doubt that small to medium businesses (“SME’s) play a vital role in business in Australia and are a major employer. However, it should also be remembered that almost 80% of corporate insolvencies involve less than 20 employees. Many SME’s that were trading unprofitably before Covid-19 are likely to struggle post the pandemic as well – but having racked up more debt.

The Corporations Act enables a company that is insolvent or likely to become insolvent via the Voluntary Administration process a mechanism to see if it can be restructured, even repurposed by agreement with creditors so that it is fit for the future. If this can’t be done, then it also enables a process to maximise the returns for creditors. As an alternative, if upon proper consultation and analysis there is no way to save the company, then perhaps an exit strategy (involving a voluntary liquidation process) may be appropriate. Whilst these types of formal appointments should not be rushed into, they are quite often very real considerations for SME’s that are not otherwise easy to restructure or repurpose in an informal way. It is vital though that proper professional guidance is obtained – that means directors should avoid relying on the internet alone and / or dodgy pre-insolvency advisors.

Of course we must remember that behind every company there are directors and employees that have invested a lot of blood, sweat and tears. There are then also supportive suppliers and customers that have traded with the company. Many of these suppliers are SME’s!

However, it is unrealistic to prop up zombie companies. They are no good for those that interact with them. The key problem is that they continue to operate when they are already walking dead. They can do this because creditors don’t pursue them and the directors won’t cease trading. Ultimately, they end up making healthy companies sick because they can’t pay their bills.

Whilst we cannot doubt the extent and impactful stimulus and other supportive measures announced by the Federal and State Governments, we should be concerned that such stimulus is likely to be used by zombie companies that were already operating unsustainable business models pre Covid-19. If left unchecked this could lead not only to an increase in zombie companies, but also an increase in the insolvent nature of pre Covid-19 zombie companies.

My understanding is that the ATO will only slowly awaken from hibernation in pursuing company tax debts. The ATO is typically a very prevalent creditor in SME insolvency. Hence, it is quite likely zombie companies will use such opportunity to game the system, making harder for other genuine competitors in the industry to get growth – ie think about how your pricing changes if it doesn’t allow for paying your taxes! A word of warning, directors are now also personally liable for a company’s GST, in addition to Pay-As-You-Go and Superannuation Guarantee Charge (“SGC”).

As we now start to come out of hibernation, businesses need to carefully think about who they are transacting with and how they assess the zombie company risk. After all, cash has been and always will be king.

Whilst insolvency appointments have fallen of a cliff during Covid-19, SME’s need to consciously and diligently consider arrangements with key customers, operating margins and model scenarios based on a range revenue projections. After all, failing to plan, is planning to fail. We can help SME’s consider their current positions and navigate them through this next period.