- The new legislation emphasises that continuous improvement should not give way to concerns as to personal liability.
- The objective of the legal reforms is to encourage innovation and informed risk-taking by directors, even if that might involve the incurring of fresh debt while their company is insolvent.
- This article outlines five practical steps for directors of companies faced with financial distress.
It's still too early to declare if a cultural change amongst company directors has emerged from the safe harbour reform. What is becoming prevalent though is a 're-alignment of interests,' as directors see themselves less distracted by personal exposure in hard times, enabling them to focus their attention on remediation measures.
When Parliament finally gave a green light to wide-raging reforms to Australia's insolvency laws in September 2017, a paradigm shift for directors was in sight. It has been widely agreed that, for directors and creditor's alike, Australia's insolvent regime had been failing.
After eight months of operation, it cannot yet be said that the new legislation has resulted in a cultural change among company directors. However, advisers working with boards of companies in circumstances of financial hardship are at least starting to see directors less distracted by thoughts of personal exposure and more fully focused on the exploration of remediation options.
This trend is unlikely to become a 'culture' of greater innovation, as hoped by the proponents of this new legislation, at least until such time as Australian directors come to appreciate the relationship between the existence of the safe harbour and their general statutory and common law duties of care and diligence.
So what does this relationship look like?
Upon a company becoming insolvent, directors face the risk of personal liability for debts incurred by the company thereafter. In cases where a director's failure to prevent an insolvent company from incurring a debt is shown to be dishonest, the director faces a risk of criminal prosecution.
It is difficult to say whether this risk of personal liability has, in the past, resulted in premature appointments of voluntary administrations. However, the anecdotal evidence is clear that, at the time when a company most needs its directors to be focused on the interest of the company, the 'insolvent trading' regime was forcing them to become distracted by considerations relating to their own personal exposure.
For the vast majority of directors; those who are genuinely engaged in seeking continuous improvement in the standing, performance, reputation and financial position of their company, it is an unfortunate distraction which could force their hand, such that optimal outcomes might be missed due to the imperative of immediate, formal insolvency proceedings.
On the other hand, the central common law and statutory duty of company directors is the general duty to exercise powers and functions with the degree of care and diligence as would a reasonable person in the same position. That general duty would dictate that, even in circumstances of insolvency, or possible insolvency, directors ought to take the steps which a reasonable person would take with a view to improving the position of the company, even if the restoration of solvent trading is unlikely.
In cases where there was a clear restructuring path which was likely to restore the company to solvent trading, even before the recent law reform directors had some flexibility; either by arguing that, if solvency was likely to be restored in a reasonable timeframe, the company was not technically 'insolvent', or by relying upon the defence in s 588H(2) (ie the director believed, on reasonable grounds, that the company was solvent at the time the relevant debts were incurred).
However, in all but very clear cases of short-term lack of liquidity, the situation was extremely uncomfortable for directors in times of financial distress caused by events like:
- revaluation of assets
- damage to assets
- litigation against the company
- loss of significant contract(s)
- decline in commodity value
- loss of market or market share
In cases where no clear restructuring plan existed which would have justified the directors of a distressed entity in concluding that the company was in fact solvent (ie the directors had an expectation of solvency), the previous regime imposed a duty (or, at least, implied a duty) on directors to cause the company to cease incurring fresh debts (in effect, to cease trading). In practical terms this meant that voluntary administration was the only 'safe harbour' available to avoid personal exposure.
While the new law leaves untouched the previous 'insolvent trading' framework, it creates an overlay whereby that framework will not apply in certain circumstances. Prior to introduction of that overlay, there was some debate as to whether it was to create a limitation on the breadth of the underlying contravention or, rather, a new defence for directors. In the end it doesn't much matter, as the legislation clearly provides that the onus of proof, as to whether or not the protection applies, lies with those who wish to rely upon it. In most cases, that will be directors who are defending an insolvent trading claim.
The substantive reform provides (by insertion of a new s 588GA into the Corporations Act2001) that the 'insolvent trading' prohibition does not apply to a person (being a director), in respect of a debt incurred by the company, if the debt is incurred during a period in which the person is developing one or more courses of action that are reasonably likely to lead to a better outcome for the company than immediate formal insolvency proceedings (ie, administration or liquidation). Similar protection is granted to a holding company which might otherwise be liable for debts incurred by an insolvent subsidiary (see s 588WA).
Although this new law is yet to receive judicial consideration, it is generally accepted that a matter is 'reasonably likely' if it is more than just fanciful; more than just a hope. Therefore, it is not necessary for the proposed course or courses of action, which are intended to produce a 'better outcome for the company', to be certain to succeed in that objective, or even to be more likely than not to succeed. A significant element of risk is acceptable. After all, the whole objective of these legal reforms is to encourage innovation and informed risk-taking by directors, even if that might involve the incurring of fresh debt while their company is insolvent.
The new legislation also provides some guidance as to the sorts of things which a court will take into account in assessing whether or not a director had a basis to conclude that a particular course of action would lead to a better outcome. They include whether or not the director is, at the relevant time…
- properly informing himself or herself of the company's financial position
- taking appropriate steps to prevent any misconduct by officers or employees of the company that
- could adversely affect the company's ability to pay all its debts
- taking appropriate steps to ensure that the company is keeping appropriate financial records
- consistent with the size and nature of the company
- obtaining advice from an appropriately qualified entity who was given sufficient information to give
- appropriate advice; or
- developing or implementing a plan for restructuring the company to improve its financial position.
The 'Safe Harbour' regime imposes a threshold requirement, such that the immunity afforded to directors will most likely not apply in respect of any period during which the company is substantially failing to:
- pay employee entitlements on time; or
- give all required notices, returns…etc under the Income Tax Assessment Act 1997.
So, it can be seen that the new regime provides directors with a mandate, together with some guidance, to fully exercise their general duty to explore all remediation options; the central question being whether the directors have identified a plan, or plans, with the intention to 'lead to a better outcome for the company' (with reasonable likelihood).
True to the allegory of calm, safe waters, the 'safe harbour' reform has been widely touted in terms of the immunity it affords to directors, from exposure to personal liability, when the open waters become choppy. In fact, that perspective masks the real significance of the reform, as directors have always had the ability, indeed the duty, to strive for continuous improvement of their corporation's standing, reputation, performance and overall financial position, even in troubled times.
The real significance of the new legislation is the confirmation that the focus on such continuous improvement should not give way to concerns as to personal liability. Specifically, the implied paramount duty to appoint administrators, upon the onset of insolvency, is removed in recognition of the paramountcy of the wider duty to engage with the task of considering all possible remediation options (of which administration is just one) — a true re-alignment of interests.
Practical tips for directors
Step 1: Information
- It is imperative, particularly in times of financial distress, that directors have access to accurate and up-todate information. It will be difficult for directors to credibly claim that they were pursuing a 'course of action', for a better outcome, if their planning was not based on good information.
- This step ought to start long before there exists any sign of financial distress. It involves the directors establishing policies which:
- prioritise the development and maintenance of good information systems
- promote a corporate culture which promotes the timely escalation of important issues to the board.
Step 2: Assessment/Options
- With the benefit of timely and accurate information, in circumstances of an event or series of events causing financial distress the directors should assess the financial position and have to hand an accurate cash-flow forecast for at least the immediate and medium term.
- Determination of whether or not the company is technically insolvent is now of lesser importance than the identification and assessment of the options which might improve the company's position. Therefore, in conjunction with assessment of financial position there should be an analysis of potential courses of action, such as:
- renegotiation of contracts
- operational improvements
- management/personnel changes
- disposal of certain assets
- financial restructure
- capital raising
- scheme of arrangement
- 'pre-pac' DOCA
- Each potential course of action ought to be assessed in terms of likely improvement of the position of the company and, in particular, how the position is improved as against the likely outcome of a formal insolvency proceeding. At least until the new law gains the benefit of some judicial interpretation, it would be prudent for directors to undertake an assessment of the likely counterfactual outcome of an immediate administrator appointment, at least in general terms.
- The identification, upon such analysis, of any reasonably likely improvement in the financial position of the company is sufficient to maintain the 'safe harbour'.
Step 3: Implementation
- Any course of action which is reasonably likely to result in a better outcome (than immediate administration) should be implemented.
- In circumstances of actual insolvency — that is to say, when the cash-flow forecast discloses existing debts which are unable to be paid in full as and when due — consideration should be given to making adjustments to expenditure in order to minimise the incurring of fresh debt (so long as that is consistent with the implementation of the overall plan).
- The time taken to implement any plan should be no longer than is reasonable. It is important to note that the 'safe harbour' does not create any moratorium on creditor action (as does the commencement of administration). It remains open, for example, for a creditor to apply to court for a winding up, if the conditions for such an application exist, notwithstanding that the directors are seeking to implement an improvement plan. If such a creditor is unable to be dissuaded from pressing ahead with a winding-up application, the directors will be forced to account for the timing of that application in their assessment of the likelihood of any proposed 'course of action' leading to a better outcome.
- Similarly, a secured lender is not prohibited from enforcing their security (such as by appointment of receivers), simply because the directors are pursuing a course of action under 'safe harbour' protection. It is for these reasons that the implementation phase of any course of action should include fulsome engagement with the company's significant stakeholders. More often than not, the success or otherwise of a plan will depend heavily on the support of such stakeholders. In any event, it is necessary for the directors to understand the position of stakeholders in making the 'reasonably likely' assessment.
- Throughout the implementation stage, directors should continually monitor the situation, keeping in mind that the 'safe harbour' protection ceases to apply upon the relevant course or courses of action no longer being reasonably likely to lead to a better outcome. If those circumstances arise, and repetition of steps 2 and 3 above does not give rise to alternative courses of action, directors may be left with no choice but to commence formal insolvency proceedings.
Step 4: Documentation
- Each of the above steps should be fully documented by the directors in order for them, in due course, to be in a positon to discharge their evidentiary onus. Bearing in mind that it is normally a liquidator who would prosecute an insolvent trading claim against directors, if the corporate record (to which a liquidator will have access) discloses that the directors have followed a 'safe harbour' course, this may in itself discourage the liquidator form instituting a claim.
- Any one or more of the above steps might involve engagement of appropriate experts (either as consultants or employees). This might include lawyers, accountants, operational or technical experts, or others, as appropriate or necessary. The engagement of such experts is likely to produce documentation (correspondence, reports…etc) which will support the directors' case that they were, at the relevant time, actively and genuinely involved in the development and implementation of a plan or plans to better the outcome for the company.
- It is not normally necessary, or appropriate, for a board of directors to delegate, in a wholesale manner, stewardship of the company to an 'expert'; rather, the directors should commission whatever assistance they need in order to progress the steps outlined above.
Step 5: Disclosure
- In the case of a listed public company, a question arises as to whether any of the above steps require disclosure under the continuous disclosure regulations. Certainly, the engagement of the 'safe harbour' does not grant immunity from disclosure obligations. However, the fact that directors are engaged in a process to develop options for improving outcomes is not, in itself, a matter for disclosure.
- That view is supported by the ASX itself which, on 9 March 2018, updated Guidance Note 8 to clarify 'whether the fact that the entity's directors are relying on the insolvent trading safe harbour in s 588GA of the Corporations Act requires disclosure to the market'. The Note now states as follows:
'The fact that an entity's directors are relying on the insolvent trading safe harbour to develop a course of action that may lead to a better outcome for the entity than an insolvent administration, in and of itself, it not something that ASX would generally require an entity to disclose under listing Rule 3.1…
The fact that they are doing so is not likely to require disclosure unless it ceases to be confidential or a definitive course of action has been determined.'
- While the fact of 'safe harbour' engagement is not, in itself, a matter for disclosure, in many cases certain matters pertaining to that engagement might require disclosure, such as:
- Any event which has impacted, or might impact, on the solvency of the company.
- Material change in financial position.
- Appointment of certain types of advisers, such as the employment of a credit restructuring officer.
- Commencement of a strategic review
- The adoption by the company of a specific plan of action
- Significant milestones in the implementation of such a plan.
- In November 2017, prior to publication of the relevant guidelines by the ASX, one company made an announcement in the following terms:
'[The company] and its directors have adopted safe harbour status…[The company] is developing a number of courses of action that are reasonably likely to lead to a better outcome for the company than available alternatives…[The company] is being advised in these matters by [Advisers].'
Evidently, that announcement followed earlier disclosures of financial distress.
- While the company's November disclosure was probably not necessary from a compliance perspective, there may have been good reasons for it from a practical perspective. Nevertheless, it is now better understood that 'safe harbour status' is not a qualification that can be claimed in real time; rather, whether or not directors have taken sufficient steps to gain the protection from personal liability afforded by the legislation is a matter to be determined, retrospectively, by a court in the context of subsequent insolvent trading proceedings.
- At a minimum, the new regime has the effect of emphasising the positive duty on directors to explore alternatives to administration. Therefore, in cases where, despite best efforts, administrators are appointed, it makes sense to include reference to those efforts in the public announcement of the administration. There have already been a number of examples of this in ASX disclosures of administrator appointments:
- Empire Oil & Gas NL: 'After careful and urgent consideration of the options available to it, the company determined that it could not develop a course of action that was reasonably likely to lead to a better outcome than the appointment of administrators.'
- OrotonGroup Ltd: 'Despite a comprehensive process, the strategic review has not resulted in any viable option for recapitalising or selling the Company at this point in time which could achieve a better outcome than voluntary administration.'