On 29 April 2016, the Federal Government released a Proposals Paper titled ‘Improving bankruptcy and insolvency laws’.

The Government is proposing these reforms to encourage entrepreneurship and investment. It hopes to reduce the stigma and detriment around failed business ventures, while still balancing the need to protect creditors.

This bulletin discusses the second of the reforms, the proposed ‘safe harbour’ for directors from the insolvent trading provisions.

Safe harbour

This proposal seeks to implement a ‘safe harbour’ in the insolvency provisions of the Corporations Act 2001 (Cth).

Two alternative mechanisms are proposed.

Option 1: a defence to section 588G

Initially put forward by the Productivity Commission in its 2015 report on Business Set-up, Transfer and Closure, this model would operate as a defence to section 588G if:

at the time the debt was incurred, a reasonable director would have an expectation, based on advice provided by an appropriately experienced, qualified and informed restructuring adviser, that the company can be returned to solvency within a reasonable time, and the director is taking reasonable steps to ensure it does so.

The Proposals Paper states that the defence would apply where the company appoints a restructuring adviser who:

  • is provided with appropriate books and records within a reasonable period of their appointment to enable them to form a view as to the viability of the business; and
  • is and remains of the opinion that the company can avoid insolvent liquidation and is likely to be able to return to solvency within a reasonable period of time.

The defence contemplates situations where a company may be experiencing difficulties such as cashflow shortages but, with proper advice, should remain viable in the long term.

To ensure the effectiveness of this defence, the onus will be placed on the company to prove that the adviser appointed is appropriately experienced and qualified.

The defence will not be available to directors who have not otherwise acted in accordance with their directors’ duties, such as where the company has failed to lodge Business Activity Statements (BAS) or failed to pay PAYG and employee superannuation.

Option 2: carve out of section 588G

The alternative safe harbour model proposes a ‘carve out’ of section 588G, stating that section 588G will not apply if:

the debt was incurred as part of reasonable steps to maintain or return the company to solvency within a reasonable period of time; and

the person held the honest and reasonable belief that incurring the debt was in the best interests of the company and its creditors as a whole; and

incurring the debt does not materially increase the risk of serious loss to creditors.

This option contemplates the safe harbour as a carve out, rather than a defence, placing the onus on the liquidator bringing a claim to show that the director has breached the provision.

The Government has suggested that ‘reasonable steps’ may include the formal appointment of a restructuring adviser and early engagement with shareholders, creditors and other stakeholders.

Directors cannot drop anchor

The ‘safe harbour’ proposal is not finalised and it remains to be seen what legislation is actually passed.

In the Proposals Paper it is clear the safe harbour will:

  • only be extended to directors of companies with good corporate governance and who are acting in accordance with their directors’ duties;
  • not provide protection for a company that is already insolvent and has no prospect of returning to solvency within a reasonable period of time; and
  • not be available, for example, where there has been a significant failure to pay employee claims, PAYG and or employee superannuation.

Even if a safe harbour is introduced, the following is clear:

  • Directors will continue to be under a positive obligation to be proactively involved in the management and affairs of the company.
  • It is not sufficient for a director to rely upon another director being in control of the day-to-day functions of management.
  • Directors should make appropriate enquiries as to the system of financial reporting to the board and must critically examine the information received.
  • Each director is obliged to maintain a sufficient understanding of the affairs of the company to be able to form an opinion as to its solvency.

The golden rule

Directors need to recognise the warning signs of financial difficulties, obtain appropriate advice without delay and to act on the advice.

Unfortunately it is all too common for directors to seek advice when the liquidator is already knocking on the door.