Under the Corporations Act 2001, directors have a duty to prevent insolvent trading. They can be ordered to pay compensation, and can even be convicted of an offence, where their company trades while insolvent. The threshold is low in that the director need only have a suspicion that the company is insolvent for the duty to be engaged. Once triggered, the duty requires directors to take steps to prevent further debts being incurred by ceasing active trading or by placing the company into administration. If prevented from doing those things, the director needs to resign.
Arguably, the risk of personal liability for insolvent trading distorts the way in which the directors of otherwise viable companies respond to a financial crisis.
While there are in fact relatively few successful cases against directors in relation to insolvent trading, our experience is that concerns about insolvent trading are, understandably, very much at the forefront of directors’ minds when making decisions about a company in financial distress. In those circumstances, placing a company into administration is a reasonable response by directors, particularly for independent directors who may have little financial risk tied up in the company. However, contrary to the intention of the administration regime, the legal consequences of appointing an administrator often see restructuring options evaporate. This increases the risk that viable (albeit financially distressed) companies are placed into liquidation and wound up.
PRODUCTIVITY COMMISSION’S PROPOSED ‘SAFE HARBOUR’ DEFENCE
In its report Business Set-up, Transfer and Closure (released to the Commonwealth Government on 30 September 2015), the Productivity Commission recommended, among other things, that directors should be protected from liability for insolvent trading while genuine restructuring is attempted with the assistance of a specialist advisor – the so-called ‘safe harbour defence’.
This recommendation was made based upon the Productivity Commission’s finding that concerns about their liability for insolvent trading were causing directors to place companies into administration earlier than necessary at the cost of not pursuing restructuring opportunities with the best possible chances of saving the company. That accords with our experiences mentioned above.
In those circumstances, the Productivity Commission proposed that it would be beneficial to introduce a defence to insolvent trading when all of the following criteria are satisfied:
- directors of a company make, and document, a conscious decision to appoint a safe harbour adviser with a view to constructing a plan to turnaround the company
- the adviser is presented with proper books and records upon appointment, and can certify that the company was solvent at the time of appointment
- the adviser is registered and has at least 5 years’ experience as an insolvency and turnaround practitioner
- directors are able to demonstrate that they took all reasonable steps to pursue restructuring
- the advice is proximate to a specific circumstance of financial difficulty (and would be subject to general anti-avoidance provisions to prevent repeated use of safe harbour within a short period)
- the adviser forms the opinion that restructure into a viable business or businesses is possible. If not, the adviser would be under a duty to terminate the safe harbour period and advise the directors that a formal insolvency process should commence.
The Productivity Commission further recommended that the defence should not attach to any particular decision to incur a debt. Instead, in order to provide directors with the freedom they need to succeed with a restructure, the Productivity Commission said the defence should apply to all actions by directors in the general running of the business and in any restructuring actions. It said the defence should operate from the time of appointment of the advisor until the conclusion of (reasonable) implementation of the advisor’s advice.
GOVERNMENT’S RESPONSE TO ‘SAFE HARBOUR’ PROPOSAL
On 7 December 2015, the Prime Minister issued the Government‘s response to this recommendation as part of his much publicised National Innovation and Science Agenda. In short, the Government has accepted the Productivity Commission’s proposed safe harbour defence.
The Government’s rationale is that entrepreneurs will fail several times before they succeed and will usually learn a lot in the process. So, to increase innovation, more needs to be done to encourage Australians to take a risk, to leave behind the fear of failure and to be more innovative and ambitious. It said that introducing the safe harbour defence would achieve that by protecting “directors from personal liability for insolvent trading if they appoint a restructuring adviser to develop a turnaround plan for the company”.
WHAT WILL THIS MEAN FOR DIRECTORS?
The proposed safe harbour defence will, in our view, help to alleviate the pressure upon directors of financially distressed companies. It will require directors to take action early and there would need to be genuine options for restructuring. But by reducing the directors’ risk of liability for insolvent trading in those circumstances, the safe harbour defence should give directors more freedom to pursue restructuring and ought to reduce the incidence of viable companies being placed into external administration prematurely.
WHAT DOES IT MEAN FOR CREDITORS?
The interests of creditors are affected in two ways by the proposed safe harbour defence:
- Potential benefit for creditors as a whole
Creditors who might otherwise have received very little in a winding up after the sale of distressed assets will instead be paid in full (or at least receive an agreed compromised amount) if the company is rescued.
- Potential detriment to creditors trading with the company during the safe harbour period
Inevitably, restructuring attempts will only sometimes be successful and many will come to nothing. So companies will continue to be placed into liquidation even after going through the safe harbour restructuring period.
In the meantime, the company may have continued to trade and incur debts to creditors during the period in circumstances where the directors would otherwise have ceased the company’s trade and/or would have appointed an administrator to the company.
While the rather rigid proposed preconditions to the availability of the safe harbour defence ought to minimise the period during which such creditors will be at risk, creditors who trade with such companies during a failed restructuring period will end up worse off than if the company had earlier ceased trading.
Almost certainly, it will be these trade creditors who will carry the burden of realising the Prime Minister’s aim of allowing businesses to be free to take more risks and learn from their mistakes.
WHEN WILL THE CHANGES BE IMPLEMENTED?
The Government has not provided any specific detail about the drafting of the safe harbour defence and has said merely that a proposal paper will be released in 2016 and the necessary legislative changes will be passed in 2017.