Two key changes made to Australian insolvency law enhance restructuring efforts in Australia and could improve outcomes for US investors.
On September 18, 2017, two recent changes to Australian restructuring and insolvency law—the introduction of a safe harbor for directors and ipso facto prohibition—received royal assent and officially became law. The safe harbor for directors is effective immediately while the ipso facto prohibition becomes effective on July 1, 2018 with respect to contracts entered into after that date. Each of these reforms will enhance out-of-court and in-court restructuring efforts of Australian companies and likely improve outcomes for US investors.
Safe Harbor for Directors from Trading While Insolvent Liability
In the United States, assuming appropriate disclosures under the securities laws and no fraudulent activity, directors are not personally liable for liabilities incurred by a company merely because it is insolvent. Insolvent companies are not required to file for bankruptcy, and companies can file for bankruptcy even if they are not insolvent. Accordingly, US companies and their directors are able, if they choose, to engage in out-of-court restructuring discussions with their key creditor constituencies, even where they are operating in a default or insolvent situation.
In contrast, prior to the reforms, in Australia directors could be held personally liable for the liabilities of a company incurred while that company was insolvent and be subject to civil and criminal penalties. Trading while insolvent liability for directors (understandably) meant that a company would not operate in a default situation without an appropriate forbearance or waiver agreement. Director liability in these circumstances was a constant overhang to any out-of-court restructuring efforts and frequently resulted in the premature appointment of administrators, often to the detriment of enterprise value and creditor recoveries. Concern over such premature appointments destroying the value of a company that might have had long-term prospects was widely shared by the Australian restructuring community and was a key driver of the reforms.
The recent reforms in Australia now provide directors of Australian companies with a “safe harbor,” namely a protection against civil liability for trading while insolvent, if, among other things, the director and the company are developing and taking actions that are reasonably likely to lead to a better outcome for the company than an immediate administration or liquidation. The Explanatory Memorandum published in connection with the law reforms cautions that “hope is not a strategy” and the safe harbor is not meant to protect directors with “fanciful” recovery plans or directors who are not acting honestly and diligently. Accordingly, to be protected by the safe harbor, directors need to have a realistic view of the outcome of the proposed restructuring plans and may be second-guessed on their assumptions regarding the success of any such proposal. The safe harbor will likely benefit US investors by preserving optionality and offering a more meaningful opportunity for restructuring discussions.
The Ipso Facto Prohibition
There are many powerful tools afforded to debtors in a US Chapter 11 proceeding. At the top of the list is the ability to assume executory contracts that are on favorable terms. Most leases and contracts contain a provision providing for the termination of the agreement upon a Chapter 11 filing or other insolvency event; these clauses are referred to as ipso facto clauses. The US Bankruptcy Code renders these clauses unenforceable for most contracts (other than financial contracts, swaps, etc.). The prohibition on enforcement of ipso facto clauses is key in affording debtors an opportunity to assess their future business plan and to decide which contracts to assume or reject going forward. Favorable contract rights—e.g., in supply contracts—can be among a debtor’s most valuable assets, and preserving valuable contract rights is often instrumental in the feasibility of a debtor’s reorganization.
The US Bankruptcy Code’s ipso facto clause prohibition was historically unique to US restructuring law, a body of law that prioritizes providing debtors with an opportunity to reorganize over facilitating creditors’ immediate recovery on their claims. Over the years, as their insolvency regimes shift toward facilitating reorganization in addition to, if not instead of, liquidation, other jurisdictions have adopted similar provisions preserving contract rights and restricting enforcement of ipso facto clauses.
In Australia, prior to the reforms, parties were entitled to terminate their respective contracts based on an ipso facto clause if their contract counterparty commenced administration or liquidation proceedings or if a receiver was appointed. Like trading while insolvent liability, the termination of contracts solely as a result of an ipso facto clause frequently frustrated restructuring efforts, was value destructive to a company, and adversely affected recoveries of all creditors. The reforms now provide for a stay (or prohibition) of the enforcement of ipso facto clauses by contract counterparties on most contracts. Similar to the US statute, the Australian law includes enumerated exceptions to the law, including swaps, derivatives, and similar financial contracts. The reforms do not affect a party’s ability to terminate a contract for non-performance or non-payment by the company in administration.
So What Does This Mean for US Investors?
By removing the overhang of trading while insolvent liability for directors engaging in reasonable and good-faith restructuring endeavors and prohibiting the termination of contracts that are vital to a company’s business operations, the recent law reforms increase the ability of Australian companies to restructure out of court and through administration, thereby improving creditor recoveries.