It is a concern for directors in charge of companies experiencing financial difficulty that they may fall foul of the provisions under the Corporations Act 2001 (Cth) regarding a director’s duty to prevent insolvent trading by a company.

New legislation was passed by the Parliament last week which will introduce a carve-out to directors’ obligations to companies in times of corporate distress. Namely, the “safe harbour” provisions introduced in the Treasury Laws Amendments (2017 Enterprise Incentives No. 2) Bill 2017 will act as a shield to protect directors against personal liability for insolvent trading if certain conditions can be satisfied. Companies will effectively be able to carry on trading even when the company’s solvency is unclear if it can be demonstrated that the company’s directors are taking action that can lead to a better outcome for the company than the immediate appointment of an administrator or liquidator.

The current legislation

Under section 588G(2) of the Corporations Act 2001 (Cth) (Corporations Act), a director may be personally liable for the insolvent trading of a company if:

(a) he or she is a director of the company at the time when the company incurs a debt;

(b) the company is insolvent at that time, or becomes insolvent by incurring that debt, or by incurring at that time debts including that debt; and

(c) at that time, there are reasonable grounds for suspecting that the company is insolvent, or would so become insolvent, as the case may be.

There must also be grounds for the director to suspect the company’s insolvency or that it would be reasonable for a person in such a position in the circumstances to become aware of the company’s insolvency.

Strict insolvent trading regime

The current insolvent trading regime in Australia can be described as counterproductive as the potential penalties against directors may actually deter directors from seeking to relieve a company’s financial distress through legitimate means outside a formal insolvency process (such as entering into informal negotiations with creditors, pursuing entrepreneurship opportunities to rescue the company or by seeking to attract new investors to back the business) over concern of being taken to have aided a company to trade whilst insolvent. From a policy standpoint, the current laws arguably:

(a) encourage directors to prematurely seek external administrators in order to protect themselves from personal liability;

(b) hasten a company’s entry into a formal insolvency process which may result in a loss of the company’s value as key contracts terminate due to ipso facto clauses (see more below) and important assets are abruptly sold (along with the erosion of goodwill); and

(c) discourage directors from taking proactive and diligent steps to save a company on the brink of insolvency which will often lead to negative outcomes for creditors, employees and shareholders of the company.

New exception to directors’ personal liability

The new safe harbour provisions essentially provide breathing space for directors to take control over the financial restructuring of a company when it is reasonably likely that it will result in a better outcome for creditors, employees and shareholders than if the company entered into a formal insolvency process.

The Treasury Laws Amendments (2017 Enterprise Incentives No. 2) Bill 2017 (the Bill) provide an exception under the new section 588GA of the Corporations Act to a director’s personal liability for insolvent trading if certain actions by the director can be demonstrated after insolvency is suspected.

Essentially, the director must prove that they took a course of action reasonably likely to lead to a better outcome for both the company and its creditors as a whole in order for the safe harbour provisions to apply.

The Bill provides a non-exhaustive list to aid in this determination which includes whether the director:

(a) took steps to prevent any form of misconduct within the company that could impact the company’s ability to pay its debts;

(b) took steps to keep financial records;

(c) obtained appropriate advice;

(d) informed themself of the company’s overall financial position; and

(e) implemented, or began to develop, a plan to restructure the company to improve its financial position.

If a director can produce evidence to the Court that their course of action would reasonably likely lead to a better outcome, the onus of proof shifts to the individual alleging insolvent trading (in most cases, the liquidator) to prove that safe harbour does not apply. Importantly, the above factors are not definitive and the Bill, together with the accompanying Explanatory Memorandum, indicate that each course of action will turn on the facts. The protections afforded under safe harbour will also apply even if the company is ultimately placed into a formal insolvency process.

Practical considerations & key takeaways

  • Directors in companies experiencing financial difficulty should take action immediately to benefit from the safe harbour protections – a passive approach will not reward you.

  • It is important to practice good corporate housekeeping – the safe harbour provisions will only apply if the company is meeting all of its employee entitlements (including superannuation payments) and tax reporting obligations consistent with a company that is solvent and has followed the proper maintenance of the company’s books and records.

  • Beware of new financing – only debts incurred in connection with the course of action reasonably likely to lead to a better outcome will be covered by the safe harbour provisions. A director may still be personally liable for insolvent trading if it cannot be demonstrated that they believed the company could repay the debt.

  • Directors must continually satisfy safe harbour conditions during the entire restructuring process – the protection will only be afforded to directors who monitor their course of action at every stage of the restructuring process to ensure compliance with the new requirements. In circumstances where restructuring may take months, directors should be mindful of staying on top of their obligations under the new provisions.

  • The new legislation is not yet in force – directors should be aware that the commencement date of the Bill is the day after the Bill’s assent by the governor general (which has not yet been proclaimed).

Note on ipso facto clauses

In many commercial contracts, it is a common clause that one party can exit or terminate the agreement in circumstances where the other party experiences an insolvency event (e.g. the winding up of a company or its entry into voluntary administration). For a company in financial distress, the termination of a major commercial contract usually will spell its financial demise as well as damage its goodwill and ability to pay a return to outstanding creditors. Under the amendments introduced by the Bill, two kinds of stay provisions will enliven in such circumstances (subject to certain excluded contracts):

(a) an automatic stay on ipso facto rights when a company enters a formal insolvency process; and

(b) stay orders where a Court considers such rights may not be exercised solely because the company has experienced an insolvency event.