The insolvent trading "safe harbour" and "ipso facto" clause reform

The key points

Last week, the federal government circulated an exposure draft of the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill (the Bill). The Bill is intended to promote entrepreneurship and innovation among directors of companies facing insolvency - this is to be achieved through two fundamental changes to existing insolvency laws.

  • In a pre-insolvency context, company directors will be afforded a "safe harbour" from personal liability for insolvent trading in certain circumstances when the company is restructuring outside of a formal insolvency procedure.
  • In a formal insolvency context, 'ipso facto' clauses (which presently enable termination or amendment by a solvent counterparty in the occurrence of an insolvency event) will no longer be enforceable in the context of a proposed scheme of arrangement (under Part 5.1 of the Corporations Act 2001 (Cth) (Corporations Act) or a pending voluntary administration (under Part 5.3A of the Corporations Act), merely on the basis that the distressed company has entered into a formal insolvency process.

The intention behind the first reform is to drive cultural change in Australian business and encourage directors to maintain control of their company, including by taking steps to facilitate its turnaround by taking reasonable risks.

The limitation on the operation of ipso facto clauses - adopting similar limitations in place in the US and elsewhere in Asia Pacific - is intended to allow greater scope for a successful restructure and/or the sale of a business as a going concern (with reduced value destruction) where a company is in distress.

First proposed in December 2015, no date has yet been set for the first amendments (regarding "safe harbours") to take effect. The second set of amendments (regarding ipso facto clauses) is proposed to take effect from 1 January 2018. In the meantime, the Bill is open for comment from the public - the Baker McKenzie team will be involved in providing feedback on the Bill in the near future.

The detail

I. Insolvent trading - the "safe harbour" defence

For those following the law reform process, the Bill sees the proposed adoption of the Model B reform - changes to the insolvent trading duty and the defence available to directors - while the alternative Model A proposal, involving the establishment of a more comprehensive "safe harbour" procedure, has not been pursued.

New section 588GA The "safe harbour" is to be effected by insertion of a new s 588GA of the Corporations Act. The provision is intended to shield directors from a contravention of the insolvent trading duty (s 588G of the Corporations Act) if they take a course of action that is reasonably likely to lead to a better outcome for the company and its creditors and the debt was incurred as part of the course of action. Whether a course of action is reasonably likely to lead to a better outcome is judged on an objective basis.

Limitations on the safe harbor Among other restrictions on the extent to which this protection is available, directors will not be able to rely on the "safe harbour" if the company is not meeting its obligations in relation to employee entitlements (such as superannuation) or its taxation reporting obligations. This is a manifestation of the fundamental condition of the "safe harbour" - that directors act honestly in their management of the company. The change is intended to incentivize early, honest engagement in circumstances of financial distress and for directors to attempt to facilitate their company's recovery (instead of premature entry into voluntary administration or liquidation).

Temporal aspects of the safe harbour Directors who successfully claim the safe harbour will receive protection from the time they commence taking a course of action for a "better outcome". They will continue to enjoy the safe harbour until either (i) that course of action is complete, (ii) the company goes into administration, or (iii) what they are doing ceases being reasonably likely to lead to a better outcome.

This last end-point to the safe harbour will occur once it becomes clear that the company cannot be viable in the long term. In making that assessment, the size, nature and complexity of the company will be considered, and some loss-making trades may be accepted even where solvency is doubtful.

What is a "better outcome"? A "better outcome" for purposes of the safe harbour is defined as being where creditors as a whole and the company are better off than they would have been under an externally administered body corporate.

Is a course of action reasonably likely to lead to a better outcome? There are a number of factors that a Court may consider in judging whether or not a course of action is reasonable, for example, directors:

  • taking steps to prevent misconduct by officers and employees of the company;
  • ensuring appropriate financial records are kept; and
  • remaining informed about the company's financial position.

The explanatory memorandum to the Bill explains that none of these factors are requisites, and only serve as a guide. There may be circumstances where even a company's taking on of additional debts will be accepted - and the safe harbour made available - provided the debts were reasonably likely to lead to a better outcome.

Evidence and burden Should the company proceed into external administration, directors claiming the safe harbour defence from action by a liquidator must have evidence that the course of action that they took was reasonable. That evidence can only be drawn from books and information that has been made accessible to the liquidator. After a director provides some evidence, the burden shifts onto the liquidator or other party seeking to prove the course of action was not reasonable.

This requirement emphasizes the critical importance to directors of properly documenting their deliberations and actions when dealing with circumstances of financial distress for their company.II

II. Ipso facto clauses

Stay on enforcing rights - schemes and voluntary administration The Bill will see the insertion of new stays on the enforcement of rights against companies the subject of schemes of arrangement and restructures through voluntary administration if those rights have become enforceable only because of the fact of the company becoming subject to an arrangement or restructure. That prohibition on enforcement will extend to, for example, rights to terminate contracts or accelerate payments due by the debtor company.

In the case of schemes of arrangement proposed for "Part 5.1 Bodies" (i.e. local or registered foreign companies), the stay is only available when the application for a scheme of arrangement states it is being made for the purpose of avoiding winding up.

Period of the stay The rights that are subject to the stay are not enforceable:

  • in the case of a scheme of arrangement, from the time when the application for Court approval of the scheme is made until when the application is withdrawn, dismissed, results in a compromise or arrangement, or when the Part 5.1 body is wound up;
  • in the case of an administration, from when administration begins until administration ends, or any proceedings regarding extension orders finish, or the company is wound up.

Also, in the context of an administration, applications for extension orders may be made by companies that have entered into a deed of company arrangement following an administration and which are already the subject of orders limiting the rights of secured creditors, owners or lessors of property.

Rights excluded Importantly, certain rights will not be subject to the stay. These include:

  • rights under contracts entered into following either (i) an application for Court approval of a scheme of arrangement being made, or (ii) the company entering administration;
  • rights prescribed by regulation or the subject of ministerial declaration, including those in contracts of the Commonwealth or contracts of a kind for which the rights are commercially necessary;
  • rights managing financial risks of products (under Chapter 7 of the Corporations Act) where the enforceability of the right is commercially necessary.

Price of the stay: contracts for additional credit not enforceable In return for receiving the stay, the Part 5.1 body (in the case of a scheme of arrangement), or the company subject to voluntary administration, cannot enforce any right for additional credit it has against the other party while the stay is in force. This avoids a solvent counterparty having their exposure to the distressed company deepened, unless of course the solvent counterparty agrees.

Lifting the stay A Court may lift the stay:

  • in the case of a scheme of arrangement, if either (i) the scheme of arrangement is not for the purpose of avoiding a winding up of the Part 5.1 body, or (ii) lifting the stay is appropriate in the interests of justice;
  • in the case of an administration, if lifting the stay is appropriate in the interests of justice.

In either case, an application for the stay to be lifted may be made by the holder of the rights - ie, the person whose rights are the subject of the stay.