27 September 2018

The dialogue is changing yet is the law enabling the practical change directors need?



This article was written by Tony Troiani and Philip Pan.

The dialogue is changing yet is the law enabling the practical change Directors need?

Achieving significant cultural shift in any business environment is no easy task, so it’s by no means ground-breaking to declare that after 1 year in operation, it still cannot be said that the new “Safe Harbour” legislation has resulted in a cultural change among directors.

What is emerging from the boardroom tables is a change in the dialogue and thought process that directors are now having where businesses are facing financial distress – and this in itself is a strong testament to the change the legislation set out to achieve.

Conversations trickling out from boardrooms across Australia is that those advisers who are 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 focussed on the exploration of remediation options.

Yet, should we be further along the path of ‘cultural shift’, one year on? We think so.

‘Safe Harbour – 1 Year On,’ examines the new legislation in its practical context and suggests some “tweaking” which may bring about the increased certainty that Directors need in order to fully embrace the reform.

This piece outlines:


At the first anniversary of the director insolvent trading “safe harbour” protection, it is timely to reflect on whether this reform is achieving its objective and to consider possible improvements to provide greater clarity as to its practical application by directors and their advisors.

 


The principal objective of the safe harbour protection is to “drive cultural change amongst company directors by encouraging them to keep control of their company, 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”.[1]

Although it is still too early to declare if a cultural change amongst company directors has emerged from the safe harbour reform, it is clear that the protection is being relied upon in practice by directors in both large and smaller restructures.  It is also clear that some advisors are embracing the opportunity for innovation and change more than others, with some still viewing the management of potential conflicts and the scope of their “appropriate” advice through a traditional and overly technical lens.

It is also still too early to determine whether key stakeholders such as banks and other secured creditors (who are currently strongly motivated by reputational considerations), Unions, FEG, ATO, unsecured creditors, customers and shareholders are supportive of the reform.  In practice, it seems that many of these stakeholders have little awareness of the reform or how to react to protect their interests.  Nevertheless, an important part of any safe harbour restructuring is the implementation of a clear stakeholder management and communications strategy.  No doubt the strategy to be adopted in each matter will need to be evaluated on its own individual circumstances, at least in the absence of some uniform industry practice and court or regulatory guidance.  The safe harbour protection largely shifts the credit or restructuring risk to unsecured creditors and, more particularly, the ATO who, in essence, bridge the liquidity or funding gap.  For this reason, the ATO’s approach and the way it utilises the expanded single touch payroll reporting[2] and its proposed new powers (for example,  to retain refunds and pursue directors personally for GST liabilities[3]) will impact the future utility of the safe harbour protection for many directors.

Case Studies

In this article, we propose to highlight some of the issues seen in practice by reference to the real life experiences of two companies which have recently passed through a period of significant financial distress.

Small Co

SmallCo is a small joint venture vehicle between S1, a large publicly listed company, and S2, an individual who had developed a technology solution which had considerable application in the business of S1 (and, potentially, elsewhere).

Due to the delays with the refinement of the software, and differences of opinion between the two shareholders as to the best direction for the company, conflict arose between the shareholders and SmallCo became dysfunctional.  The disputes escalated to the point where S1 made a demand, in respect of a shareholder loan, which the company could not repay.  The company was, therefore, insolvent.

Rather than awaiting the inevitable winding up application, the directors of SmallCo developed a “course of action” which involved seeking to broker a deal between S1 and S2.

LargeCo Ltd  

LargeCo is a well established, not for profit, community based company providing a range of services in the areas of disability, health, aged care, family and children.  The company has 150 members, employs around 900 staff and services approximately 2500 people each month in various States.  In addition to its range of funded programs and services supported by over $60M in government grants annually, it conducts cafes, retail, travel, plant nursery, indoor rock climbing, gym and other social operations.  Given the roll out of the National Disability Insurance Scheme (NDIS), LargeCo’s income stream is now received monthly in arrears rather than quarterly in advance.   The government and financier have declined the company’s requests for further funding.  The company has received various offers for the sale and five year leaseback of several of its specialised properties at a premium.  The directors do not receive any remuneration.  There are collective bargaining agreements covering the employees, with potential priority employee entitlements (including redundancy) of up to $10M.  

The directors were considering various potential courses of action ranging from acceptance of the sale and leaseback arrangements to pay down debt to the transition of some or all of its operations to a new partner or operator.

 


One of the matters to which a court may have regard, in determining whether a course of action was reasonably likely to lead to a better outcome for the company, is whether the director seeking safe harbour protection was obtaining advice from an “appropriately qualified” person.[4]  There has been a lot of attention within the profession directed to the question of what are the appropriate qualifications of a safe harbour advisor.  However, in practice the issues which have arisen are more around the structure of the advisor retainers and the scope of the “appropriate” advice required to be given to the directors to maximise the prospect of safe harbour protection.

The retainer issues include whether the advisor’s client should be the company or the directors,[5] the relationship between co-existent safe harbour and administration advisors (1 role or 2 roles?), the preservation of legal advice privilege (on a common interest basis) and the minimisation of the risks associated with managing existing and future conflicts.  Other issues include the extent of required ASX disclosures and the risk of avoidance of the safe harbour advisor’s  fees in any subsequent liquidation.

There is also a divergence of views as to the scope of the safe harbour advice and what is “appropriate”.  For example, the ASX disclosure by Condor Blanco Mines Limited[6], in relation to its “adoption of safe harbour status” stated: 

"Condor is being advised in these matters by W Advisers... W Advisers have provided further guidance rather than concluded opinions on compliance with s588GA. Condor has also engaged with Ferrier Hodgson... for the purpose of exploring options available via the voluntary administration process."

On the other hand, TMA Australia’s best practice guidelines, on navigating the safe harbour regime, state that the safe harbour advisor should “provide a view to the board as to whether Safe Harbour is available” and “be prepared to provide a “better outcome” opinion on the turnaround plan. The means taking a view on whether the plan is objectively likely to produce a better outcome”.

In practice, this has led those directors adopting a more conservative approach to engage an advisor to prepare comparative administration, liquidation and restructuring plan assessments, or counterfactuals, of the estimated “cents in the dollar” return, similar to those commonly found in second reports to creditors issued by administrators, and to test the reasonableness of the underlying assumptions adopted by the directors.  Leaving aside the obvious risks assumed by the advisors in that role, it is clearly in the best interests of the directors to obtain specific advice on the better outcome assessment, which the TMA states, “will require careful legal and financial analysis of the individual circumstances and options.”

The prevailing view has been that a “safe harbour advisor” role is a separate one entirely to a “prepare for administration” role.  It is thought that a person undertaking the role of safe harbour advisor could not subsequently take the role of administrator because that person might later have to form views about the recoverability, as an unfair preference, of their own remuneration (as pre-administration advisor) and about the veracity of their own pre-administration advice.  That concern was starkly ventilated in the matter concerning the appointment of Korda Mentha partners as administrators of Channel 10.[7]  In that case, O’Callaghan J of the Federal Court agreed with the joint view of the parties to the effect that the mere fact that the appointees had done work, even significant work, for the company prior to their appointment did not necessarily preclude them from accepting the formal appointment.  However, His Honour indicated that, in undertaking the pre-administration work, “appropriate safeguards” should be adhered to in order to avoid any appearance of conflict should a subsequent appointment become necessary.  Appropriate safeguards might include:

  • Advising the directors that the prospective administrators might later have to investigate their conduct, and even take action against them.
  • Ensuring that the prospective administrators do not participate in the inner sanctum of decision-making.
  • Retaining good records of the retainer and the work performed under it.

The Court also decided that the issue of the pre-appointment fee recoveries being potentially preferential did not require disqualification of the administrators but, in that case, could be appropriately dealt with by way of appointment of a special purpose liquidator to prepare a report to creditors on that limited subject.

Whilst maintaining the 3 safeguards noted above, it seems possible for directors to obtain, from a single, pre-administration advisor, views on many of the critical matters required for “safe harbour” status, including:

  • an opinion as to solvency (including assistance, as necessary, with preparation of cash-flow forecasts and the testing of underlying assumptions);
  • views on likely course and outcome of an immediate administration (administration “playbook”) or liquidation.
  • views on how the likely outcomes of different, out of administration, courses of action might compare with the immediate administration or liquidation outcomes.
  • views on the benefits or detriments associated with a delay to the taking of immediate formal action.

There are obvious efficiencies in the advisor who undertakes the above carefully constrained role also becoming the administrator, if administration turns out to be the best option for the company.

The Channel 10 decision pre-dates the Safe Harbour laws.  Precisely where the line is to be drawn, defining the limit of pre-administration advice able to be given by a person subsequently appointed as administrator, is yet to be tested in the context of those new laws.  However, it is clear enough that, if a person is to be kept clear of conflict for a subsequent formal appointment, they must not enter the “inner sanctum” of decision-making and should not provide the “better outcome” advice referred to by the TMA.  The un-tested proposition is whether or not any distinctions can be drawn between advice which merely outlines what the possible outcomes of certain “courses of action” are likely to be, versus active involvement in the development of possible alternative courses of action and the giving of opinions as to which course might produce a “better outcome”.

SmallCo Pty Ltd

In the case of SmallCo, the warring parties (the shareholders, S1 and S2) both had separate legal representation.  Two of the three board members, who were formally nominees of S1, sought independent legal advice from our firm regarding insolvent trading and “safe harbour” issues.  The third director was S2.

Whilst S1 initially indicated that it simply wished the joint venture to be dissolved, via a voluntary administration process, to their credit the S1 nominated board members, independently advised, took the view that their general duties as directors, exercised within the safe harbour regime, required them to persist with efforts to broker a deal between the shareholders, outside of administration.  They believed that an administration would destroy any remaining value in the goodwill of the company.

So, instead of immediately placing the company into administration, the board resolved to engage a firm of insolvency accountants to take preliminary steps to prepare themselves and the company for administration in the event that a formal appointment became necessary.  That “Channel 10” style appointment enabled the accountant advisors to provide the sorts of opinions and views outlined above and, in this case, that was sufficient to give the directors confidence to persist, at least for a short time, with their out of administration strategy.  

It was hoped, by the S1 nominated directors, that the engagement of insolvency experts to “prepare for voluntary administration” would encourage the shareholders, particularly S2, to engage in meaningful negotiations to avoid that costly, and probably fatal, outcome.  This was the essence of the “course of action” adopted by the directors.

Large Co Ltd

In the case of LargeCo, the auditors were providing various services to the company but not in respect of management decisions. The directors adopted a conservative approach and engaged our firm and an independent restructuring firm, as joint safe harbour advisors (on a common interest basis), to provide specific advice on the availability of safe harbour protection and a better outcome opinion in accordance with TMA's guidelines. In this case, the company also sought guidance from a separate firm of registered liquidators as to the voluntary adminitration process.

 


The requirement to compare the expected outcome of the proposed “course of action” with an immediate administration (as opposed to liquidation) is unhelpful.

The problem with this formulation is that, in light of the enormous flexibility inherent in the voluntary administration regime[8], the exercise of comparing likely outcomes of a “course of action” outside of administration, as against the likely outcome of an administration, is a difficult one to apply in practice.  In most cases, a course of action undertaken outside of administration could also be undertaken within administration, with similar ultimate outcomes.  In many cases, the outcome via an administration might be superior, particularly if a cleansing of liabilities and the balance sheet is required.  After all, the entire object of an administration is to facilitate the rehabilitation of insolvent companies or, at least, optimise the return to creditors.

This difficulty has been heightened by the commencement of the ipso facto reform on 1 July 2018[9] which deals with the stay of contractual enforcement rights which are enlivened merely because a company has formally entered administration.  Prior to the commencement of that reform, it was often the case that the formal appointment of administrators gave rise to an immediate risk that the company’s contracts (in particular, with suppliers and customers) and associated goodwill or going concern value would be lost.  The existence of the risk of immediate loss of valuable contracts upon administration meant that a comparison of likely outcomes of an out of administration “course of action”, as against a hypothetical immediate administration, was more readily made and could more readily be found to be favourable. Although the ipso facto reform only applies to contracts entered into after 1 July 2018, there remails the potential for a court to apply the stay more broadly.[10]

So, an unintended side-effect of the ipso facto stay reform (which in itself is a welcome change), to the extent it applies in administration, has been that it is now more difficult, and some would suggest practically impossible, for directors and their advisors, in a pre-administration scenario, to become credibly satisfied that a proposed “course of action” is likely to result in a better outcome than the immediate commencement of formal administration.  Whilst it is true that voluntary administration will always have a level of stigma attached to it, which is potentially value-deflating (not to mention the additional fees and costs burden it produces), directors carry a difficult onus of actually proving this in the event they ultimately find themselves defending an insolvent trading claim.

The current formulation of the “safe harbour” positions voluntary administration as one of the comparators to other, more informal options for corporate recovery.  Philosophically, that brands voluntary administration as corporate “failure”, rather than maintaining its position as a powerful and flexible gateway for business recovery or, if that is not possible, efficient and optimal winding up.  The true manifestation of corporate failure is liquidation, not administration.  Administration should, rather, be viewed by directors as just one of the myriad tools available to them in order to discharge their general duty to produce best (or, at least, “better”) outcomes.

It is submitted that the safe harbour protection would be significantly improved by the removal of reference to appointment of an administrator from the definition of “better outcome”.  The comparator should simply be that of an immediate liquidation.  The adoption of a more commercially realistic approach by the courts to restructuring and value breaks on a hypothetical or counterfactual liquidation basis supports this view.[11]

SmallCo Pty Ltd

The directors of SmallCo found it very difficult practically impossible to genuinely and effectively engage with the question of whether their proposed course of action would produce a “better outcome” than an immediate administration.  Their hope was that, by promoting on-going negotiations between the shareholders, it would be possible to achieve an outcome whereby S2 acquired the shareholding of S1 and recapitalised the company.  However, it was not clear that the same outcome could not be achieved through a voluntary administration.[12]  Whilst there were suspicions that a voluntary administration would deflate the value of the enterprise, that was impossible to prove, let alone quantify. 

There is no doubt that the anxiety level of the directors, who were clearly seeking to do the right thing by the company, would have been reduced if comparison with an immediate administration was not a constant element of the equation.

LargeCo Ltd

For the directors of LargeCo, the absence of further funding and support from the secured creditor and numerous state and federal government departments (who collectively would have the ability to effectively control any administration and the viability of any proposed deed of company arrangement for the company to continue in existence), meant that they were faced with the prospect of a very uncertain administration process or immediate closure and liquidation of the company. 

The uncertainty and risks led to the directors seeking (from the “safe harbour advisors”), detailed counterfactual plans, together with administration and liquidation outcome assessments.  This resulted in further costs and delays.  The uncertainty with the roll out of the NDIS and transition from an advance to accrued funding model made it difficult to assess the viability of the cashflow forecasts and thereby apply the better outcome test. 

There can be no doubt that, throughout this difficult period, the unremunerated directors of this not for profit company had no other objective than to produce the best possible outcome.  Whilst they gained some comfort by obtaining advice as to what the administration and liquidation outcomes might look like, it was a tangible source of anxiety to the directors to know that, in the event their plan failed and the company was ultimately liquidated, their comparative assessments (undertaken under considerable pressure, in real time) might later be subjected to detailed scrutiny (with hindsight vision) by a court in the context of an insolvent trading claim.

 


In the case of a liquidation, the overall objective is very clear and the role of the liquidator (being the person then in control of the company) is very clear – it is to get in and realise the property of the company and to distribute that value in accordance with well established priorities.

In the case of administration, the overall objectives are also clear – to maximise the chances of the company (or its business) continuing to (solvently) exist or, failing that, to produce a better return to creditors than an immediate winding up.[13]  A great amount of flexibility is afforded to administrators as to how they might meet those objectives; however, the objectives are specific (continued existence or better return to creditors) and measureable. 

In the case of safe harbour status – that is to say, an insolvent or potentially insolvent company which is implementing a “course of action” – the objective is neither clear, nor readily measurable.  The only guidance given in section 588GA is that there must be a reasonable likelihood of a “better outcome for the company”.  A company, of course, is a rich tapestry of stakeholders – trade creditors, shareholders, employees, directors, suppliers, customers, lenders (secured and unsecured), the ATO, other regulators and (in the age of corporate responsibility or social licence) even the community at large – all of whose personal interests are not necessarily aligned at various times during the life of the company.  A better outcome for one might not be a better outcome for another.  Even individuals within a single class might have different specific interests (for example, one creditor might prefer to receive a lesser payment, more quickly). 

The prevailing view is that the general law of directors duties requires directors to focus their attention on the interests of creditors, when circumstances of financial distress arise.  However, as noted above, not even administrators have that focus, as the optimal return to creditors is only the default objective of a Voluntary Administration under Part 5.3A; the primary objective is the continued existence of the company or its business.

The current formulation of the “safe harbour” leaves unanswered the question of whether the reference to “better outcome for the company” means, in fact, a better financial return (ie cents in the dollar) for creditors generally, or a better likelihood of continued existence (of the company or the business); or whether it has some other meaning.  The extent to which non-tangible or wider public benefits can be taken into account in the better outcome test is uncertain.  Further, there is uncertainty as to whether the better outcome test is satisfied by a restructuring plan which contemplates a later formal process (administration/scheme/ liquidation), and the cessation of trade by the company; for example, to simply complete a sale or a project. 

The application of the better outcome test seems to shift the focus from a traditional cashflow analysis, based upon the ability to pay debts as they fall due, to the balance sheet.  This requires a fundamentally different approach to restructuring and allocation of value between stakeholders by insolvency practitioners.  As most companies during safe harbour will incur more debt (in the absence of an equity injection or urgent asset sales), and hence increase its liabilities, the issue is essentially whether this will be offset by the other benefits of the restructuring plan which will disproportionately favour some stakeholders over others.  It is unlikely that a creditor in a subsequent formal insolvency, who was not a creditor prior to the safe harbour period, will view this as a “better outcome”! 

There does not appear to be any good reason why the policy (objectives) behind Part 5.3A of the Corporations Act should not also apply during the twilight zone of pre-administration insolvency or potential insolvency.  Under that policy, directors would have a clear mandate to adopt a course of action:

(a)        to maximise the chances of the company or its business continuing to (solvently) exist; or

(b)        if that is not possible, to produce a better return to creditors than an immediate winding up.

Given that those are the objectives of an administration, in one sense the current formulation of the “safe harbour” – to produce a outcome which is better than that – gives directors an impossible task.

SmallCo Pty Ltd

The approach taken by the directors of SmallCo was consistent with the above conception of the safe harbour.  Their primary objective was to see the company and its business survive the period of financial distress (caused by shareholder disharmony) and continue to exist into the future. 

While the negotiations between the shareholders were progressing, the company was continuing to trade, to a limited extent.  Fresh trade debt was being incurred, on a daily basis, notwithstanding the company’s insolvency.  The directors were very conscious of the fact that, in the event of an ultimate liquidation, it was unlikely that those debts would be repaid in full.  Therefore, they knew that the status quo could not continue for an extended period.

LargeCo Ltd

In the case of LargeCo, the proposed course of action ultimately adopted by the directors included a form of “phoenix” in that the assets where transitioned to a new not for profit operator without any valuation or testing of the market in a relatively short period of time with upfront funding provided by the new operator.

Although often criticised, the use of a phoenix company is recognised as a legitimate business restructuring tool in appropriate circumstances.  The critical issue in any restructure is the determination of the value break or, in other words, the fair market value of the assets being transferred.  In practice, the difficulty is often in ascertaining which assets are owned by which of various related entities, the available market, the basis of the valuation and the qualifications/independence of the valuer.

It is interesting to note that the recently announced illegal phoenix avoidance reforms propose a carve out for “creditor-defeating” dispositions made in connection with a restructuring under safe harbour protection without the need for a valuation or testing of the market.[14]

In the case of LargeCo, it was clear that a restructuring plan based on the company continuing in existence, simply to transition its business to a new service provider, would provide a better outcome for its employees, customers and the community.  On the other hand, this was at the expense, or risk, of the ATO and the company’s unsecured creditors, who would not be paid in full during the safe harbour period or in any subsequent liquidation. 

Another challenging issue which arose in the restructuring of LargeCo was whether the directors were entitled to safe harbour protection, in the event they implemented the alternative plan of the sale and leaseback of properties, in circumstances where there were doubts about whether the company would be able to meet the new future five year lease liabilities in light of uncertainties within the industry arising from the NDIS roll out.  An associated issue was whether any restructuring plan, based upon the application of the proceeds of sale to pay down debt, the continued existence of the company and drawdown of finance, could run for a period of five years and the application of the “better outcome” test over such prolonged period.

Throughout the restructuring of LargeCo, the directors lived with the discomfort created by the vague notion of a “better outcome for the company” test.  The directors would have undertaken the process with far greater confidence if the safe harbour more specifically promoted proposed courses of action genuinely intended, and reasonably likely, to achieve the objects of Part 5.3A.  The directors of LargeCo were clearly focused on the first limb of those objects.

 


Directors remain concerned that, in the retrospective court determination of whether they qualify for “safe harbour” protection, the question will be whether, at the relevant time of the incurrence of debt in an insolvency context, a better outcome was “reasonably likely” as a result of a proposed course of action. In circumstances where this assessment will be made after the company has gone into liquidation, notwithstanding that course of action, directors are left exposed to a probability assessment undertaken in the clinical environment of a courtroom, possibly some years after the event.  The Explanatory Memorandum which accompanied the reading of the Treasure Laws Amendment (2017 Enterprise Incentives No: 2) Bill suggests that it was intended that the expression “reasonably likely” would establish a low probability threshold.  However, the words themselves have a different connotation.

It is likely that directors would embrace the safe harbour reform more enthusiastically if, rather than simply requiring the better outcome to be “reasonably likely”, the requirement was expressed as the relevant director having a genuine and rational belief that a better outcome was reasonably likely.  This would also serve to reduce the need (and associated cost) for the safe harbour advisor to test the viability and reasonableness of the assumptions underlying the restructuring plan. Although, some safe harbour advisors in practice are limiting their retainers and simply assuming the correctness of the directors’ assumptions (for example, regarding the likelihood and timing of suggested equity injections), in giving their “appropriate” advice, without looking at the degree of certainty of that event actually being achieved.

The notion of rational belief already exists in the Corporations Act in the context of the directors’ duty of care and diligence – see section 180 (in particular the “business judgment rule” in section 180(2)).

Under the above alternative formulation the safe harbour rule would sit more comfortably with directors’ general duty of care, in that the protection will apply unless:

(a)        the director in question did not, in fact, hold the required belief; or

(b)        no reasonable person, in the circumstances, could have held the required belief.

The “safe harbour” would be considerably clearer, and perhaps align better with what was intended by Parliament, if the “reasonable likelihood” criteria gave way to a test more akin to the “business judgement rule” set out in section 180(2) of the Corporation Act. After all, the decision to undertake a “course of action” is a business judgement call.

Adoption of the business judgment rule in this context would further underscore (as is the case) that the “safe harbour” reform is less about insolvent trading exposure and more about the duties of directors generally, in an insolvency context.[15]

SmallCo Pty Ltd

The requirement of “reasonable likelihood” was another source of discomfort for the directors of SmallCo.  The negotiations between S1 and S2 extended over a period of some four weeks.  As the directors were closely monitoring those negotiations, they were aware of the “ups and downs” of the negotiations, and the occasional deadlocks.  At one stage, when negotiations appeared to have broken down, the directors suggested the introduction of a professional mediator.

Ultimately, an independent mediator was not required.  However, for the directors of SmallCo the likelihood of a successful implementation of their plan ebbed and flowed with the negotiations.  Those negotiations never reached such a degree of impasse that it became irrational to continue to believe that a resolution between the shareholders was possible.  It might have been different if one or other of the shareholders had unambiguously advised the board that they were no longer prepared to negotiate or, perhaps, if S1 had served a statutory demand in respect of the debt owed to it.

LargeCo Ltd

was a challenging one for LargeCo’s directors that involved ongoing review and uncertainty.  The extent of the available government funding and “transition” were subject to ongoing negotiations and due diligence by major stakeholders following the entry into the initial heads of agreement.

One of the critical issues for LargeCo was the extent to which the company would avoid triggering priority notice and redundancy entitlements, and the number of employees who would be offered new employment.  This was dependent upon the likelihood of any business being transferred and whether employment would be offered on more or less favourable terms and whether prior service would be recognised; all of which are uncertain and complex issues.  Indeed, given the uncertainty, the Union commenced Fair Work Commission proceedings during the safe harbour period.  For these reasons, it may be timely to consider potential industrial relations law reform to provide greater clarity as to the transmission of business and recognition of prior service tests to align with the objectives of the insolvency law reform. 

It was also very difficult and challenging for the directors to maintain control of the communications with the employees, customers and other key stakeholder, resulting in much confusion as to the effect of the company’s safe harbour status.

 


The threshold requirements of timely payment of employee entitlements and lodgement of tax documents[16] are unwieldy and are having the effect of disqualifying a number of boards of corporations which might otherwise actually be restored to a position where they can pay employees and make tax lodgements.  Although a relaxation of this threshold requirement might mean that even directors of a company with a poor employee and tax compliance history might be able to qualify for safe harbour protection, that protection should cease immediately upon the occurrence of a fresh compliance failure during the safe harbour period.

In many instances of distressed companies, the tax lodgement threshold in particular requires a complex (and occasionally inconclusive) investigation to be undertaken before it can be determined whether the safe harbour might apply or continue to apply.  The phrase “taxation laws” is defined[17] to include a wide variety of taxes imposed under federal legislation administered by the Commissioner of Taxation including income tax, GST, PAYG withholding, luxury car tax, wine equalisation tax, superannuation contribution and fringe benefits tax.  In the often urgent context of a corporate insolvency, that is an unwarranted distraction from the primary task of identifying any possible courses of action.

An alternative to the current formulation would be for the safe harbour regime to require that any extant failures to pay employee entitlements or lodge tax documents must be addressed as part of any proposed “course of action”.  Another (less attractive) alternative would be to exclude from the tax lodgement requirement some of the less material taxes.

SmallCo

The directors of SmallCo were confident that they qualified for safe harbour protection, insofar as these threshold requirements were concerned.  For a small, private company, compliance with these requirements is relatively easily determined and there should be limited occasions in which threshold qualification for safe harbour protection is uncertain for these threshold reasons. 

LargeCo Ltd

In the case of LargeCo, the company's tax position was quite complex.  Further, the company had at least two previous failures to comply with its obligations and was on a repayment plan with the ATO which it could not maintain.  This made it critical that a closely monitored tax lodgement plan was implemented as any failure during the safe harbour period would result in immediate loss of director protection.

Another uncertain threshold issue experienced in the LargeCo restructure was the extent of the protection during the initial decision making period (which may range from a few days to “even months”) when the directors are considering various restructuring options and still obtaining initial advice and stakeholder input.[18]  For example, how does one determine which debts are incurred in connection “with any such course of action” and does the better outcome analysis run from the safe harbour or restructuring plan commencement date.  In the case of LargeCo, there were not insignificant debts incurred during the one month period prior to the adoption of the formal restructuring plan by the board of directors.  Although it is in the interests of directors to trigger the safe harbour protection as soon as possible, it may be worth considering the pre-requisites and scope of protection during this initial period.

 

SmallCo Pty Ltd

The outcome for Small Co was a happy one. The resolution for the Board to appoint insolvency practitioners to prepare for a voluntary administratoin had the desired effect of promoting deeper and more compromising discussion between shareholders.

Ultimately, a commercial transaction was agreed whereby S2 acquired the whole of S1’s shareholding in the company and a services agreement was reached whereby S1 would support the business, as a customer.  S2 provided funding which resolved the debt due to S1.

Large Co Ltd

Again, the outcome for LargeCo was a good one for the customers and the 600 or so employees who transitioned to the new operator with support from the federal and state governments.  Following the implementation of the restructuring plan, the company was placed into administration and then liquidated with the funding gap during the safe harbour period ultimately being borne by the ATO and other trade creditors.  The transmission employee entitlement gap was principally met by FEG.

 


The safe harbour reform has generally been accepted as a positive step forward and has the potential to drive a cultural change if its objectives are embraced by advisors to directors and key stakeholders, particularly the ATO and FEG.  Further guidance from ASIC and the ATO as to their approach to dealing with directors and safe harbours would be welcome.[19]

We have suggested that the policy behind the safe harbour reform would be enhanced, and directors encouraged to further embrace the reform, with the following changes:

(a)        The definition of “better outcome” should fix the comparator as the immediate appointment of a liquidator, as opposed to the immediate appointment of an administrator, or liquidator. 

(b)        The vague notion of “better outcome for the company” should be more precisely aligned with the objects of Part 5.3A of the Corporations Act.

(c)        The “reasonably likely” test should give way to something more akin to the rational belief test set out in the business judgment rule in section 180(2) of the Corporations Act.

(d)        Reform of the industrial relations laws should be considered, to create greater alignment of the transmission of business and recognition of prior services tests with the insolvency law reforms. 

It is submitted that these refinements would facilitate the cultural change which was hoped for, without tipping the scales too far, appreciating that directors are being given a mandate to manage the distressed company (including by incurring fresh debt), without any court or independent administrator / liquidator supervision.

Given the nature and extent of the current legislative insolvency reforms, it is important to ensure that the various reforms compliment each other in their practical application so as to avoid any unintended complexity or consequences by shifting the legitimate restructuring risk back to the directors personally or unduly favouring certain stakeholders.

For more, ready Toni Troiani's article, Safe harbour: A realignment of interests


[1] Explanatory Memorandum, Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017, page 3 and also see paragraphs [1.12] to [1.16]

[2] From 1 July 2018, employers with 20 or more employees must report to the ATO through single touch payroll. From 1 July 2019, single touch payroll reporting will be mandatory for employers with 19 or less employees

[3] Treasury Laws Amendment (Combatting Illegal Phoenixing) Bill 2018

[4] Section 588GA(2)(d)

[5] Strictly speaking, section 588GA(2)(d) refers to “the person” (ie the director personally) obtaining advice

[6] Stock exchange announcement made on 27 November 2017

[7] Korda, in the administration of Ten Network Holdings Ltd (administrators appointed) (Receivers and Managers appointed) [2017] FCA 914.

[8] Part 5.3A of the Corporations Act

[9] Part 2 of the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017 which commenced 1 July 2018

[10] By application to the court for orders under section 447A of the Corporations Act

[11] For example, see In the matter of Nexus Energy Ltd (Subject to Deed of Company Arrangement) [2014] NSWSC 1910

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[12] Under section 444GA of the Corporations Act a transfer of shareholdings can be effected by the administrator of a deed of company arrangement (with the approval of the relevant shareholder, or with the leave of the Court)

[13] Section 435A of the Corporations Act

[14] Treasury Laws Amendment (Combatting Illegal Phoenixing) Bill 2018

[15] See: “Safe harbour: A realignment of interests”, T.Troiani, Governance Directions, June 2018.

[16] Section 588GA(4)

[17] Section 995-1 of the Income Tax Assessment Act 1997

[18] Explanatory Memorandum, Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017, paragraphs [1.39] to [1.47]

[19] ASIC Regulatory Guide 217 Duty to Protect Insolvent Trading: Guide for Directors last updated in July 2010


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