The limits of safe harbour protection

As the recent Victorian Supreme Court decision in Re Balmz Pty Ltd shows, trading while insolvent can have dire consequences for company directors, writes Professor Jason Harris.

The economic fallout from the COVID-19 pandemic has raised legitimate concerns for the financial viability of large numbers of Australian businesses. While the federal government implemented protections for company directors against insolvent trading from March until the end of 2020, the lifting of these protections at the end of the year coincided with the easing of a range of other financial support measures offered by banks, landlords and the government’s Jobkeeper scheme.

This will put significant pressure on many businesses, large and small, and some may not survive. Indeed, it is likely that many businesses have been insolvent for some time, even before the pandemic hit. The winding back of protections against insolvent trading this year will add another risk for directors to manage. It is natural for directors to believe that insolvency is not something that will happen to their business.

For many, it’s easy to imagine that insolvency comes as a sudden shock, with a severe decline. The reality for many businesses is that insolvency is the bottom of a slow, gradual decline. Bills ignored soon pile up, creditor demands increase and, all of a sudden, a company’s debt problems can seem insurmountable.

For many SME directors, the pressure of dealing with debts can be too much to bear, and it may seem easier to just focus on working on the business.

The recent decision of the Victorian Supreme Court in Re Balmz Pty Ltd demonstrates that this approach can lead to disastrous consequences. The judgment — which is the first to examine the safe harbour from insolvent trading liability legislated in 2017 — highlights that directors who trade on in the hope that everything will work itself out will be left unprotected.

The scope of insolvent trading liability and safe harbour

Section 588G of the Corporations Act 2001 (Cth) prohibits directors from allowing their companies to trade at a time when the company was insolvent and there were reasons to suspect that the company might be insolvent, where either the director was aware of the reasons or a reasonable person would have been aware of them. Where this occurs, the director can seek the protection of the safe harbour provision under s 588GA, which provides a defence where the director took action that was reasonably likely to lead to a better outcome for the company.

While the optimal outcome is obviously for the company to survive and all debts to be paid, insolvent trading liability only arises when the company fails and ends up in liquidation, so the safe harbour protects directors even if their attempts to save the company fail. However, there are several exceptions and carve-outs for the safe harbour, including a failure to pay employee entitlements or to keep tax office lodgements up to date.

A cautionary tale

The Balmz case concerned the shareholders and directors of Balmz Pty Ltd, which owned and operated a cafe and a takeaway store. The managing director’s husband was also a director, but had outside employment and was not involved in managing the business. The company failed to lodge tax activity statements for five years, with the ATO issuing several notices and reminders. Suppliers and other creditors took legal action in order to recover debts and the company owed more than $50,000 in unpaid rent.

In 2011, the ATO conducted an audit of the company, which also revealed unpaid superannuation and unpaid PAYG. This was originally slightly more than $20,000 but with late penalties soon grew to almost $60,000. After this, the ATO issued a garnishee notice over the wages of the husband; then issued a statutory demand on the company claiming more than $100,000 in unpaid taxes. The company appointed a business adviser to assist with resolving its tax problems, but this was wholly ineffective. Several months after receiving the statutory demand, the directors placed the company in voluntary administration.

The company had secured bank debt guaranteed by the directors. The focus of the directors was primarily in paying down the bank debt by selling personal assets and raiding their superannuation accounts. By the time of the administration, the trade creditors had been mostly paid, with the ATO and bank loans being the major debts. The company was then wound up by the Federal Court.

Crucially, the company failed to keep adequate financial records as its computer had malfunctioned, and the managing director did not rebuild the records. This led to a failure to lodge tax documents for several years. The directors had not drawn wages from the business for several years and were largely reliant on their savings. They had also lent the company hundreds of thousands of dollars in order to pay trade creditors.

Aside from engaging a business adviser to assist with opposing a winding-up application (which was unsuccessful), the only action the directors took to resolve their tax issues was to attend a meeting with the ATO in 2012 (more than four years after the problems began). The directors’ plan was to resolve the tax problems and then sell the company’s store to pay the remaining debts.

The directors claimed the company was never insolvent because they were regularly paying trade creditors out of their own money. This ignored the failure to pay tax, employee entitlements or rent on their second store. The court rejected arguments the directors’ home could have been sold to pay for the debts, given the couple had been forced to use their superannuation to keep the business operating, and even then, several large debts remained unpaid. It was also noted there was no evidence as to whether the company’s bank would support further finance secured by the family home.

Jason Harris is a professor of corporate law at Sydney Law School.

What happened next

The directors of Balmz Pty Ltd were ordered to pay over $100,000 for the insolvent trading of the company. It may be queried whether this amount would cover much more than the liquidators’ fees. It is of course possible that the directors will declare bankruptcy and the liquidator will not receive the amount ordered.

The case is a cautionary tale for company directors that they need to take action if unpaid debts start piling up. There were many things that the directors could have done to avoid this outcome, each of which required a timely response and an ongoing active monitoring of the company’s financial affairs, including:

• Responding in a timely way to the ATO warning notices
• Keeping creditors informed of the company’s situation
• Ensuring that employee super is paid up (both for the employees’ benefit and also to avoid significant penalties)
• Rebuilding the company’s financial record system when the computer broke down
• Responding to the statutory demand when issued
• Seeking legal advice when the ATO tried to wind up the company.

Overall, the case is a stark warning for directors of all companies to act early when financial problems arise. Burying your head in the sand will do nothing but allow problems, penalties and interest to snowball and you can lose your business, your life savings and your health in the process. And choose your counsel well.

The case also provides the first judicial ruling on the safe harbour and offers guidance for directors to ensure that they should fully document:

• What steps they are taking to try and produce a better outcome for the company
• What the scope of engagement for any professional adviser is
• How debts incurred during the safe harbour period are relevant for trying to produce a better outcome for the company
• What steps they’ve taken to garner creditor support for the rescue effort.