Insolvency reforms update

The Australian Institute of Company Directors’ Louise Petschler provides a monthly round-up of the Advocacy team’s key projects.

Reforms to introduce a safe harbour for directors in cases of insolvent trading are moving quickly, with the government seeking to finalise draft legislation soon. The AICD has long advocated for these reforms and welcomes the release of draft legislation. However, while the draft legislation reflected many of the AICD’s initial recommendations during previous consultations, we remain concerned with some key aspects of the proposed model. In a recent formal submission, the AICD proposed amendments to the draft legislation which, if adopted, would ensure the legislation is more workable in practice for directors.

The case for reform

Australia’s insolvency framework discourages directors from exploring innovative and sensible ways to improve the financial position of a company in distress. In effect, directors must choose between “running the gauntlet” with a restructure or workout (risking personal liability), or placing the company into administration or liquidation at no risk to themselves. This can lead to premature invocation of insolvency, resulting in job losses, contract terminations, destruction of goodwill, and overall value diminution.

The current insolvent trading regime also discourages experienced directors from joining boards of companies at the very point when they are most needed and would add greatest value. Indeed, concerns over inadvertent breaches of insolvent trading laws are often cited as a reason early-stage investors and professional directors are reluctant to become involved in start-ups.

Under the government’s proposed legislation, the safe harbour is drafted as a defence to the civil insolvent trading prohibition in the Corporations Act. It is neither a “carve out” nor an “exception”, though it has been described as such.

Directors can rely on the safe harbour protection if they commence a “course of action” which is “reasonably likely to lead to a better outcome” for the “company and the company’s creditors as a whole”.

Once the course of action ends, is no longer likely to lead to a better outcome, or the company is placed into administration or liquidation, the safe harbour ends. This means that directors will need to continually monitor progress.

Should a director’s course of action ever be scrutinised by the court in later proceedings, the judge will be required to examine a director’s underlying reasoning objectively. The court will not examine what a director believed would be a better outcome.

What is a better outcome?

Under the proposed model, a “better outcome” is defined as an outcome which is better for the company and the company’s creditors as a whole, than the outcome of the company “becoming a Chapter 5 body corporate” (entering into liquidation or administration).

This means that company directors must compare at least two future scenarios when determining whether to use the safe harbour:

1. The likely outcome which would follow from a “course of action”.
2. The likely outcome which would follow if the company was placed into formal insolvency processes.

If a reasonable possibility exists that a better outcome will result from (a) when compared with (b), and a director can provide some evidence of this possibility, then the safe harbour protections will apply. The AICD has some significant concerns with the proposed reform. These include:

• The safe harbour requires directors to undertake a counterfactual analysis, which involves comparing a number of predictions about possible future events. These predictions may need to be made under time pressure and with imperfect information. The AICD is concerned that directors simply will not use the safe harbour, given how challenging these requirements are.
• In conducting the counterfactual analysis, directors will be making decisions in real time, under deadlines, and often with incomplete information. However, should things not go to plan, the decisions of directors will inevitably be judged retrospectively, and on an objective basis. Because of this, the AICD is concerned that the section does not sufficiently protect directors from inappropriate hindsight review by the court.
• Directors are expected to choose an outcome, which would lead to a better outcome for the company and the company’s creditors as a whole. The AICD is concerned that this requirement is ambiguous, departs from the current law relating to directors’ duties, and may even modify directors’ duties in the general law.

Next steps

In addition to making a formal submission on the proposed reforms, the AICD has been engaging directly with treasury in an attempt to improve the draft legislation so the safe harbour will be workable in practice and achieve its aims. The AICD expects that the government will introduce finalised legislation to parliament this year.