After years of advocacy, the AICD welcomed news that the Federal Parliament has passed a bill to introduce a “safe harbour” from personal civil liability for insolvent trading — under certain circumstances.
The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 amended the Corporations Act 2001 (Cth) with safe harbour provisions
that commenced on 19 September this year. The bill also introduces a stay provision, which affects the enforceability of “ipso facto” clauses during an administration or scheme of arrangement. This component commences on 1 July 2018 (or earlier by proclamation).
Under insolvent trading laws in s 588G(2) of the Corporations Act 2001 (Cth), a director of a company can be personally liable for debts incurred by the company if, at the time the debts were incurred, there were “reasonable grounds” to suspect that the company was either insolvent or would become insolvent.
The AICD criticised these laws as being harsh and inflexible. Without any safe harbour protection in place, they inappropriately promoted overly risk-averse behaviour by directors. Directors were essentially encouraged by the legal framework to place companies into premature administration, even where there were reasonable prospects of a turnaround, with all the wealth destruction and economic damage this can entail.
This reform is not a “free pass” for directors, who must continue to carefully oversee the the solvency of firms.
Importantly, this reform is not a “free pass” for directors, who must continue to carefully oversee the solvency of firms. The safe harbour will apply only under certain circumstances and is subject to compliance with tax reporting and employee entitlement obligations.
How does it work?
The safe harbour is designed to support company directors to pursue an active turnaround or recovery strategy with protection from civil insolvent trading liability. It provides honest, diligent directors with an opportunity to remain in control of the company and attempt reasonable innovative and entrepreneurial solutions to solve financial difficulties.
A company director will not be civilly liable for insolvent trading if they start developing one or more courses of action “reasonably likely” to lead to a “better outcome” for the company than the immediate appointment of an administrator or liquidator. Because each company is different and the reasons for a company being in financial distress will vary,the safe harbour is not prescriptive in terms of what the course of action needs to achieve or when. What constitutes a better outcome isn’t predetermined by the legislation and will likely differ for each company, depending on the circumstances.
When assessing whether the course of action will lead to a better outcome, directors don’t need to contemplate every eventuality and compare that to the appointment of an administrator or liquidator. They do need to assess the situation based on the available information and decide what needs to be done.
The safe harbour legislation recognises that not all restructuring attempts or turnarounds will succeed. However, should a director later be subject to an allegation of insolvent trading, they will need to show evidence of a reasonable possibility that their course of action would have led to a better outcome. A passive approach to the business position, or a superficial plan not based on evidence and analysis, will not be sufficient.
All existing Corporations Act duties continue to apply, including that of directors to exercise their powers in good faith with care and diligence in the best interests of the corporation.
How confident of success do directors need to be?
Directors need to be confident that the course of action is “reasonably likely” to lead to a better outcome for the company than immediate appointment of an administrator or liquidator. This will vary on a case-by-case basis. “Reasonably likely” means there is a chance of achieving a better outcome that is “not fanciful or remote” but “fair”, “sufficient” or “worth noting”.
The legislation also suggests steps for directors to consider when assessing whether their action will lead to a better outcome. These are to:
• undertake a thorough assessment of the company’s financial position;
• prevent any kind of misconduct by officers and employees of the company, which may include assessing compliance and monitoring systems and ensuring conflict management is maintained throughout the period of financial distress;
• ensure that the company continues to maintain financial records;
• obtain appropriate advice from an appropriately qualified adviser; and
• develop or implement a plan to restructure the company.
When determining who to seek advice from, directors should consider the professional qualifications, professional indemnity coverage and any applicable ethical codes of conduct that apply to the professional. The larger the business, the more likely a more complex advisory team will be needed.
What else should directors do to ensure safe harbour protection?
Certain factors would make the safe harbour unavailable. These are:
• where the company is not meeting its obligations to properly pay employees’ entitlements as they fall due (including superannuation); and
• where a company has failed to comply with its taxation reporting obligations.
For any period in which a company is not compliant with these obligations, the safe harbour will not protect directors.
Finally, if the company does fall into formal insolvency, the safe harbour will be taken not to have been available if a person substantially fails to comply with their obligations to assist an administrator, liquidator or controller in formal insolvency.
Directors must provide all the books and information they’re required to provide to an administrator or liquidator. If they fail to do this, they will not be entitled to rely on these books or information as evidence supporting their claim for safe harbour protection in a later proceeding.
- A startup seeking to scale up
Bob and Louise develop a successful app that quickly gains popularity. Deciding to expand
their business, they form a company and appoint themselves directors. As the business expands and they become concerned about cash flow, they seek the assistance of more experienced directors.
Angus has significant experience guiding startup and scale-up businesses and agrees to come on board. While he has identified the cash-flow problems and risk of insolvency,
Angus agrees to become a director knowing that he will have the benefit of safe harbour and not be personally liable for the company debts as long he develops a course of action reasonably likely to lead to a better outcome.
Angus puts in place proper corporate governance procedures and uses his contacts to negotiate a line of credit to fund the expansion of the company.
- Meeting employee entitlements and safe harbour
Henry is the sole director of a small hardware business. His accountant advises him that the company may soon become insolvent so, with the help of his accountant and a professional turnaround adviser, Henry starts developing a plan to restructure the company to improve its financial position.
The plan requires the company to incur debts while insolvent, but it is reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator.
To reduce the financial pressure on the company, Henry also decides to stop paying his employees’ super guarantee contributions, intending to pay them back when the company is on a more sound financial footing. As a result of this decision, Henry will be unable to rely on the safe harbour, as the company failed to pay its employees’ entitlements as they fell due.
These case studies are based on scenarios presented in the explanatory memorandum of the bill.