This article was written by Tim Klineberg, Paul Schroder and Carone Huang.
The perception of Australia as a relatively “risky” place to sit on a board, arises in no small part from the insolvent trading prohibition in section 588G of the Corporations Act 2001 (Cth) and how it interacts with general directors’ duties.
Our own market research into the attitudes of directors of Australian companies to the risk of insolvent trading has indicated that the risk of personal liability for insolvent trading has impacted directors’ decision making when companies experience financial difficulties.
Aversion to risk is not necessarily a bad thing for directors. However, where a company is on the precipice of insolvency it is widely accepted that continuing to trade as a going concern outside of administration or liquidation can preserve value and restructuring options. The question which requires judgment is when those options have been exhausted or are no longer in the best interests of the company or its creditors.
The safe harbour provisions enacted in September 2017 are aimed squarely at this issue. This paper examines the impact and implications of safe harbour based on our experience in restructuring situations where the safe harbour has been in effect. A review of the safe harbour provisions will be conducted 2 years after they were introduced. This paper is part of our engagement process with our clients ahead of the review, to ensure active involvement in improving the provisions.
The insolvent trading prohibition
The insolvent trading prohibition applies to directors of companies which incur debts when they are insolvent and there are reasonable grounds for suspecting that the company is insolvent at that time.
A key issue in insolvent trading proceedings is proof of the company’s insolvency at the relevant time. Solvency is primarily a cash flow test – the question is whether the company can pay its debts as and when they fall due. There are subtleties in the solvency test which lead to complexities in insolvent trading cases. Liquidators generally require expert evidence to establish insolvency.
That said, once the company’s insolvency has been established at the relevant time, directors are “on risk” simply by being on the board at the time the relevant debt was incurred. The onus is then on directors to establish one of the applicable defences, which again leads to complex disputes between directors and liquidators.
In a policy sense, the insolvent trading prohibition shifts the “blame” onto individual directors for the consequences of corporate failure. There have always been suggestions that Australia is perceived as a “high risk” jurisdiction for directors, particularly when companies are trading on the brink of insolvency. In this respect, the insolvent trading prohibition has a lot to answer for: it remains a concern that unnecessary damage is done when administrators have been appointed too early on the “safety first” basis.
In our view, this has been more of a cultural issue than a legal one. Insolvent trading may be occurring, but insolvent trading proceedings against directors (particularly successful ones) are relatively rare.
The safe harbour provisions
It is in this context that the safe harbour provisions were enacted in September 2017.
The Explanatory Memorandum made it clear that the objective of safe harbour was to “drive cultural change amongst company directors”. It specifically encouraged directors to “engage early with possible insolvency and take reasonable
risks to facilitate the company’s recovery instead of simply placing the company prematurely into voluntary administration or liquidation”.
The legislation aligns safe harbour relief to directors that are able to demonstrate the pursuit of “one or more courses of action that are reasonably likely to lead to a better outcome for the company”. Debts incurred whilst the company is engaged in those pursuits are not subject to insolvent trading risk, even if the company is later found to be insolvent when the debt was incurred.
Since September 2017, the safe harbour process has been very much part of the recommended approach to trading during financial difficulties and to managing insolvent trading risk. In our experience, the relevant considerations for directors can usefully be divided into four separate parts:
“Course of action”
The onus is on the director to demonstrate that the company is pursuing an identifiable “course of action”.
This translates to a series of steps which the company is taking to seek to achieve a better outcome. Both the “course of action” and the steps being taken should be specifically identified and minuted.
The course(s) of action being pursued must be reasonably capable of implementation. For example, prospective sales require a real bidder with real interest in and capacity to complete. Debt rescheduling negotiations with creditors must have genuine prospects of reducing the company’s debt burden.
Directors should regularly review the prospects of success of the course of action during attempts to restructure, and should keep minutes of progress.
The “better outcome” test is a comparison of the course of action with the immediate appointment of an administrator or liquidator to the company.
| Time “period”
The safe harbour provision applies during a specified “period” of time. The time “period” aligns with the period during which the company is pursuing the relevant “course of action”.
Debts incurred directly or indirectly in connection with the “course of action” during the relevant “period” could benefit from safe harbour. This is where the rubber hits the road on the safe harbour test. The timing and purpose of incurring the debt must align with the underlying “course of action” and “better outcome” test.
The legislation specifies additional factors relevant to the safe harbour test, including whether the directors are:
- “obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice”; and
- “developing or implementing a plan for restructuring the company to improve its financial position”.
The highlighted terms “appropriately qualified entity” and “plan for restructuring” do not have defined legal meanings. Accordingly, there remains considerable flexibility for directors in adopting different courses of action for the purposes of safe harbour, and in engaging advisers. We have yet to see guidance from the courts, or emerging market practice, on these issues.
The fact remains that nobody wants to be a defendant to an insolvent trading action. The safe harbour reforms have not changed that reality.
In our view, in the safe harbour era:
- It remains the case that the only true safe harbour for Australian company directors is the voluntary administration procedure. It is only once the directors’ powers have been suspended and an independent insolvency practitioner has taken the reins as administrator, the directors are truly “off risk”.
- There is now a defined pathway for directors to follow to seek to limit their insolvent trading risk. We are seeing directors following that pathway. Whether this supports better outcomes for creditors will emerge over time. In theory, creditor outcomes should improve.
- Directors of companies in financial difficulties are tending to follow the safe harbour pathways. Anecdotally, we have seen professional advisers engaged to advise specifically on the “better outcome” test. We have also seen examples where the safe harbour provisions have focused the attention of boards on the ways in which value can be preserved outside of the administration procedure, rather than a precipative appointment of administrators.
- In the administration context, we expect safe harbour to impact the recommendations of administrators in their reports and recommendations to creditors. Insolvent trading recoveries will be harder to pursue where directors have followed safe harbour principles in their attempts to restructure prior to administration. In theory, this should encourage the recommendation of deeds of company arrangement over liquidation.
- In the liquidation context, insolvent trading actions should now be harder for liquidators to prosecute. Safe harbour expands the options for directors to raise defences and to refuse to settle claims for significant sums. The next wave of insolvent trading cases will provide clarity.
The future of safe harbour
We have not yet seen any Australian cases applying the new provisions. It may be some time before we do. Until there is case law, the effectiveness of the safe harbour provisions in bolstering director defences to insolvent trading will remain difficult to assess. The legislative objective of achieving cultural change in the boardroom will need to be re-visited in time.
For the time being, we consider that following the prescriptive safe harbour pathways is now best practice for directors seeking to navigate financial difficulties. The reform has changed the dialogue in the boardroom. The legislation requires a safe harbour review within two years of introduction and we will be consulting with you to provide input to that review. In the meantime, directors should continue to ask the hard questions of management with the comfort that however difficult the answers, there are almost always courses of action reasonably likely to lead to a better outcome if you start early enough.