Out of the ‘Safe Harbour’ and into the ‘Dry Dock’

This article was written by Tony Troiani, Samantha Kinsey, Will Heath, Nicola Charlston and Louise England.

Considerations for directors and a test for existing insolvency laws

As part of its economic response to the COVID-19 pandemic, yesterday the Government passed a 'temporary safe harbour' insolvency measure[1]. It suspends, (for six months if not extended), the current 'insolvent trading' regime whereby directors can be personally liable for debts incurred by their company at a time it is insolvent.[2]

This alert explains the key considerations for directors under the new temporary rules. It also discusses the possibility that if used wisely, the increased flexibility they allow will prove a more effective way for companies and creditors alike to navigate financial distress in the future.

A refreshed focus for directors

Upon its introduction in 2017, the 'safe harbour' was a welcome reform, as it provides directors with some breathing space to carefully consider the best course of action for a company while not distracted by the risk of personal liability.[3]

The existing 'safe harbour' is unlikely to adequately deal with an unprecedented situation of sudden, widespread distress of uncertain duration. In such circumstances, it may be difficult for directors to rationally form a view that a restructuring or other plan or "course of action" (in the language of the current legislation) would be likely to lead to a better outcome for the company than the immediate appointment of administrators or liquidators.

It is clear that directors' concerns about personal liability have loomed large in their decision-making. Late last year, King & Wood Mallesons' Directions survey tested Australian company directors' perceptions of insolvent trading risk. Our key takeaway? 54% of respondents who had faced such a situation considered the risk of personal liability or prosecution for insolvent trading to be 'very important' in their decision making. Only 32% deemed actually pursuing a course of action for the purpose of safe harbour protection from insolvent trading liability to be of equal importance.

It seems that this is the rationale behind the temporary suspension of the current rules. Even before the pandemic, a case existed for the complete removal of the 'insolvent trading' regime, which has the effect of forcing directors to consider their own personal exposure at a time when the company needs the directors to be most focussed on the interests of the company.

It is nevertheless critical for directors to understand that they remain bound by their general statutory and common law duties – that is, to act with reasonable care and diligence, in good faith in the best interests of the company and for proper purposes. The new legislation will not give carte blanche for Boards to behave as they wish, or to fail to act where action is clearly required, whether during the 6-month hiatus period or otherwise.

Preventing the company from getting deeper into debt is just one of the considerations in navigating through rough times. The unfortunate side-effect of the insolvent trading regime is that it effectively makes that the only consideration. However, if a corporate entity is viewed, as it should be, as an amalgam of a wide array of stakeholders (shareholders, directors, employees, suppliers, lenders, customers…even the community at large), rather than just creditors, then it can readily be seen that the burden on directors should be governed by the very flexible, yet comprehensive, general statutory and common law duties. Even absent an 'insolvent trading' overlay, compliance with these general duties requires greater attention to be given to the interests of creditors in times of financial distress, as they become the stakeholders most impacted by the decisions made by directors.

The distress caused by the COVID-19 pandemic and the commencement of the new temporary regime create a unique opportunity for the utility of the 'insolvent trading' laws to be tested, by their absence. Are the general duties, when properly understood, robust enough to discourage unacceptable director behaviours - including causing companies to trade for too long in a hopeless situation and, on the flip side, giving up too easily and calling in administrators when other, less value-deflating options exist.

Key considerations for directors during uncertain times

Active directing is required with the onset of the global pandemic and the widespread and dramatic changes to the current trading environment which has arisen from that. The necessary starting point is the rallying of timely and accurate information. The following is a list of key considerations for directors:

Area	Comment
Company cashflow	Gather best available information regarding the likely duration of the current crisis and its impact on the relevant company. Assess the company's financial position with the assistance of a cash-flow forecast for at least the short to medium term (companies often use a 13-week cashflow forecast). In the current circumstances, the cashflow should be extended for the estimated duration of the crisis. It is also prudent to engage an accountant to review the assumptions underpinning the cashflow forecast to give directors an independent view they can rely on in the future if solvency or safe harbour protection is disputed. Focus carefully on the company's cash flow position: How much cash does the company have and how far can this be spread? It is worth taking a risk with the company's cashflow and continuing to trade? Is the company confident that it is able to pay forecast debts as and when they fall due? What future debts will be incurred? What expenses are critical and what are discretionary? How can cash be better managed? Work out a way to extend the company's cashflow by slowing down business and eliminating unnecessary expenses. For example, is there scope to negotiate deferrals with creditors? Which Federal or State Government stimulus measures may be taken up to provide further cash flow support? Given the current uncertainty, the cashflow will have to be constantly re-visited as circumstances evolve, including the other matters noted below.
Assistance available to the company	Understand what assistance may be available to the company in terms of: State or Federal government financial support; or Regulator relief (eg ATO initiatives, relaxing of ASIC and ASX reporting requirements).
Equity support	Understand what may be available in terms of equity support, whether from existing shareholders or new investors.
Financing	The Board should: Receive a formal presentation from appropriate executives on the company's financing arrangements, including maturity, covenants and key terms. The presentation should consider various scenarios for short and medium-term liquidity and alternative funding arrangements. Seek support from financiers to extend the term of facilities, waive covenant breaches and provide other forms of accommodation to support cashflow. Avoid incurring new liabilities / making new commitments where possible.
Developing a plan	Directors should develop a plan after analysing all potential courses of action. This may involve considering steps such as: suspending all or part of business operations (ie "moth-balling") until the impact and uncertainty of the pandemic on the company's operations is less acute; renegotiation of contracts; management/personnel changes including potential staff 'stand-downs' or reductions; or financial restructure.
Implementing the plan	A realistic course of action which the directors consider is reasonably likely to result in a better outcome than the immediate appointment of administrators or liquidators should be implemented. Directors must chart a clear plan on how to achieve that better outcome. The directors should fully document their plan, specifying the steps being taken to implement it and the basis on which they consider the plan to be viable.
Record of actions	Keep careful and appropriate minutes of all board deliberations and decisions, as well as progress against any plans. Good minutes will be powerful evidence of active engagement by the directors (keeping in mind that it is very likely that, in any retrospective review of director conduct over this unprecedented period, significant tolerance will be afforded to directors who can demonstrate that they were actively monitoring implementation of the plan and were acting at all times in good faith).
Disclosure and reporting	Matters to consider on a regular basis for ASX-listed companies include: Does there need to be a profit warning? If formal guidance has been given – should that guidance be withdrawn? Do any issues arise regarding the capacity of the company to continue to carry on business? Consider the impact of these extraordinary times on annual financial reporting – will the company's auditors be able to complete an audit of the company's financials? Will the economic environment impact the company's ability to prepare financials on a 'going concern' basis?
Formal insolvency proceedings	In the present circumstances, where the emphasis is now clearly on directors' general duties and significant tolerance will likely be afforded to directors who engage with those duties in good faith, formal restructuring or insolvency processes (such as administration or creditors' schemes of arrangement) should also be considered. However, if, having actively engaged with the above steps, directors genuinely feel the situation is hopeless or the plan is no longer capable of being implemented to achieve a better outcome, then formal insolvency proceedings should be considered. Even if no appointment is made, directors should seek to gain some appreciation of what the outcome might be for the company of the immediate appointment of administrators or liquidators. For some companies, making a proposal to compromise certain or all of the company's creditors through an administration and deed of company arrangement process, might be the best way to prepare the company for life after the current crisis.
Professional advice	The safe harbour provisions were introduced in September 2017. They have not yet been interpreted by the courts. In this complex and rapidly evolving environment, companies and directors should seek specialist legal advice on directors' duties, solvency and safe harbour principles when managing companies through challenging circumstances. This area of law is evolving rapidly, particularly given the legislative changes passed today (24 March 2020). We expect the historical cases on the meaning of "insolvency" and "reasonable expectations" to remain relevant to companies and their directors. In these circumstances, it is especially important for directors to have professional guidance on mitigating their risk position when making decisions on continuing to trade.

[1] Explanatory Memorandum, Coronavirus Economic Response Package Omnibus Bill 2020 and associated Bills 2020 (Cth) (Explanatory Memorandum) [12.16]; the key initiatives are summarised in our release dated 22 March 2020 See: https://www.kwm.com/en/au/knowledge/insights/covid-19-second-stimulus-package-government-initiatives-financially-distressed-businesses-20200322

[2] The regulations, which have not yet been released, may prevent the relief from applying to certain, we expect, extreme circumstances. The laws will commence tomorrow (25 March 2020), the day after the Coronavirus Economic Response Package Omnibus Bill 2020 (Cth) received Royal Assent (see, Explanatory Memorandum [12.24]). The insolvent trading relief is not backdated.

[3] For our earlier analysis relating to the introduction of the safe harbour reforms in 2017, see https://www.kwm.com/en/au/knowledge/insights/safe-harbour-reform-higher-degree-latitude-flexibility-afforded-directors-20171121 and https://www.kwm.com/en/au/knowledge/insights/safe-harbour-realignment-of-interests-20180716.