COVID-19: Strategic use of administration

Boards dealing with even a hint of uncertainty surrounding financial viability need to consider and plan for potential options should their organisations be facing financial challenges. This new director tool offers guidance around safe harbour protection, voluntary administration and Deeds of Company Arrangement.

As Australia moves into the next phase of its COVID-19 response, organisations must prepare themselves for operating without relief and support packages. Restructuring financial positions and operations through a formal process can quickly provide protection to struggling businesses, allowing them to reset to a minimum viable platform from which to move forward, once the current uncertainties are resolved.

Given the unprecedented nature of the pandemic, even well managed businesses have been trading under difficult circumstances with reduced revenue. Temporary relief from the JobKeeper and COVID-19-related reforms have provided some assistance to business with ongoing liabilities, but when those reforms end many businesses may find continuing trading unviable. Others will require a formal restructure to address their challenges. To effectively and completely discharge their governance obligations, directors must take time now to consider their options and plans should their organisation be faced with financial stress.

Insolvency is a stigmatised term but directors should not be afraid of restructuring techniques. If planned early and with good advice, many restructuring options allow businesses to keep trading and employees to keep their jobs. Done proactively, in a controlled process, the strategic use of restructuring tools can save companies from liquidation.

Safe harbour protection

Typically, the “corporate veil” protects directors from personal liability. But, in a few exceptions, courts put aside limited liability and hold directors personally liable for their company’s actions or debts. One of these exceptions is where a company incurs a debt whilst insolvent and that debt is not repaid because the company goes into liquidation. In that case, any director in place when the debt was incurred can be sued personally to repay the business debt – a form of personal liability of directors which “pierces the corporate veil” and makes them personally liable for the company’s debts for breaching the statutory duty not to trade whilst insolvent.

Safe harbour offers directors a clear pathway for managing this insolvent trading risk.

The safe harbour provisions of s 588GA of the Corporations Act 2001 (Act) allow company directors and officers the ‘breathing space’ to restructure businesses outside of formal insolvency, providing protection from insolvent trading liabilities should the restructuring be unsuccessful.

The provisions provide, if the debt was in connection with a course of action reasonably likely to result in a better outcome for the company (such as restructuring, sale, recapitalisations or cost cutting initiatives), that directors can rely on the safe harbour defence and will not be personally liable for that debt, even if their company eventually ends up becoming insolvent and is placed in liquidation.

Pre-requisites for accessing safe harbour protection

Voluntary administration

The voluntary administration (VA) regime aims to “maximise the chances of the company, or as much as possible of its business, continuing in existence; or … if that is not possible, to result in a better return for company’s creditors than from an immediate winding up in liquidation.”

The procedure usually begins with directors exercising their power to pass a resolution placing the company into administration. Before passing the resolution, the board must be satisfied the company is insolvent or is likely to become insolvent in the near future. Once an administrator is appointed, they take over the company’s affairs in place of the board, with the power to trade the business as a going concern.

The administrator’s job is to attempt to determine a way to save either the company or its business. The aim is to administer the affairs of the company in a way that results in a better return to creditors than if the company was placed directly into liquidation, with the potential to use mechanisms such as a Deed of Company Arrangement (DOCA) to achieve this objective.

The administrator investigates the company’s affairs and prepares a report for creditors covering the reasons for the company’s failure and any proposals that have been submitted for its restructure. For simpler or smaller administrations, usually within a month, either a DOCA is approved by creditors and the company re-emerges as a solvent entity – or, if there is no DOCA, the company is wound up through the liquidation.

The power of a Deed of Company Arrangement

A DOCA is a binding arrangement between a company and its creditors governing how the company’s affairs will be managed. For example, if the company wants to restructure or propose a compromise to its creditors, a DOCA is a powerful way of binding unsecured creditors to such an arrangement. DOCAs and voluntary administrations can be used to instigate debt-for-equity swaps, the introduction of fresh, “preferred” funding or to terminate unprofitable contracts (such as leases) and to resolve disputes which would otherwise be litigated at great expense.

COVID-19 has also seen the emergence of ‘Holding DOCAs’ – used to provide breathing space for companies during the pandemic. Such DOCAs are utilised when it is not in the interests of creditors that the administration process end, or a liquidation ensue. Instead, a creditor moratorium is proposed while various recapitalisation and restructuring initiatives are explored. Such mechanisms are particularly attractive for businesses that, but for the repercussions of COVID-19, are successful and profitable.

For a DOCA to be approved, the requisite proportion of creditors must support it. Creditor voting can be by a show of hands but often a poll is called. In the case of a poll, voting is split into a number and a value test. Employees, who are often creditors, typically carry the ‘number’ vote. ‘Value’ is often held by the lender or other significant creditors, such as a secured lender (often a bank) or in some situations the Australian Taxation Office if significant taxes have not been paid. If the vote is split, the administrator has a casting vote. Generally, but not always, administrators will follow the recommendation they have made to creditors in their reporting – this could be either the DOCA proposal or liquidation. Once a DOCA is approved, it binds everyone except proprietary claimants, like landlords, or any secured creditors who did not vote for the DOCA.

Examples of businesses where DOCAs have been effective recently include Surfstitch, Napoleon Perdis and Sumo Salad.

Strategic use of the VA and DOCA process

Whilst the only avenue to using a VA and DOCA process is to determine if the company is either insolvent or likely to become insolvent, there are a range of issues that can be also uniquely addressed during an administration, leading to an optimised business being delivered on the other side.

Directors should be aware, however, that while a VA and DOCA process can deliver solutions on these types of issues with the requisite levels of creditor support, the DOCA process does involve independent scrutiny of the company’s affairs and of the steps that the directors and related parties have taken. The DOCA must make a genuine compromise to creditors and must not prefer related parties or particular classes of creditors without a proper commercial rationale. Dissenting creditors have rights to challenge DOCAs in court and disputes can arise if disclosure has not been adequate or the terms of the DOCA are oppressive or unfairly prejudicial.

Directors also need to be cognisant of the fact that nothing is certain – once an appointment is made, directors lose control and any formal say over the company’s affairs and the direction of the administration and DOCA process. While DOCA proposals can be submitted by any parties, including shareholders or directors, creditors have the final say.

Options and considerations for insolvency

Ahead of September 2020, directors should engage early (and confidentially) with their advisors to talk through potential options, including agreeing trigger events.

Utilise safe harbour protections, implement turnaround initiatives and secure additional funding to retain the status quo

This is usually the preferred option, which avoids the stigma of a formal process such as voluntary administration. It also has the advantage that “ipso facto” clauses (termination rights automatically triggered on the appointment of administrators) in key contracts are not triggered.

However, this option often requires immediate funding for continued trading, which may not be available. This is compounded by the uncertainty that trading in a post-COVID-19 world brings, with a real possibility of ongoing losses and further funding being required. Administrators have powers to borrow funds and are sometimes able to obtain funding to continue the business’ operations during administration.

Propose a Creditors’ Scheme of Arrangement

A Creditors’ Scheme of Arrangement is a proposal by the company to some or all of its creditors proposing a compromise of their debts, often in exchange for equity in the company. Creditors’ Schemes are powerful tools to restructure companies and can also release claims against third parties which DOCAs cannot do.

There are downsides to Creditors’ Schemes. They require heavy court involvement and can potentially trigger “ipso facto” clauses in contracts. Directors may also struggle to obtain the consent of impaired creditors, with approval required at 75 per cent in value and 50 per cent in number. Schemes also take longer than DOCAs to implement (several months is not unusual) and tend to be more expensive than administrations.

Due to their complex nature and the requirement for court approval, the cost of implementing a Creditors’ Scheme makes them unviable for all but very large businesses with significant financing arrangements. The recent Creditors’ Scheme implemented by Tiger Resources Limited is an example.

Place the company into voluntary administration/DOCA
This is the primary option if the company is insolvent or likely to be insolvent if the turnaround initiatives are unsuccessful. It is also the most direct and certain alternative to avoiding ongoing insolvent trading liability. As discussed above, this option triggers a moratorium on claims and pauses director liability for insolvent trading. It creates opportunities for the company to repudiate uncommercial contracts or walk away from unprofitable leases.

The disadvantages of this strategy include that it may erode value and eliminate goodwill. Claims against third parties (including personal guarantees given by directors) cannot be directly released, although such releases often form part of commercial negotiations. DOCAs can also be challenged, and the possibility always exists that restructuring plans may not be successful. Sometimes, administration can take such a toll that only a shell of a business remains. Careful pre-planning before administrators are appointed is key to achieving good outcomes from DOCAs.

The ability to execute turnaround initiatives depend on a company’s cash flow forecast, potential cost saving initiatives and quality of its recovery plan. But a careful assessment of available options provides directors the best possible chance to get ahead of insolvency issues and ensure any turnaround strategies are planned and occur either under management’s control, or with as much management input as possible.

About the author

John Park is the Head of FTI Consulting’s Corporate Finance & Restructuring segment in Australia. John has been directly responsible for some of the largest corporate administrations and turnarounds within Australia.

Kate Warwick leads FTI Consulting’s Retail and Consumer Products practice and specialises in advising and working with boards, shareholders, management and other stakeholders to maximise value and manage and mitigate risk.

Tim Klineberg is Head of Restructuring and Insolvency, Australia at King & Wood Mallesons. Tim is a leading restructuring and insolvency lawyer, with deep expertise in complex debt restructuring, recapitalisations and the management of insolvency risk.

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Disclaimer

This document is part of a Director Tool series published by the Australian Institute of Company Directors. This series has been designed to provide general background information and as a starting point for undertaking a board-related activity. It is not designed to replace a detailed review of the subject matter. The material in this document does not constitute legal, accounting or other professional advice. While reasonable care has been taken in its preparation, the Australian Institute of Company Directors does not make any express or implied representations or warranties as to the completeness, currency, reliability or accuracy of the material in this document. This document should not be used or relied upon as a substitute for professional advice or as a basis for formulating business decisions. To the extent permitted by law, the Australian Institute of Company Directors excludes all liability for any loss or damage arising out of the use of the material in this document. Any links to third-party websites are provided for convenience only and do not represent endorsement, sponsorship or approval of those third parties, or any products and/or services offered by third parties, or any comment on the accuracy or currency of the information included in third party websites. The opinions of those quoted do not necessarily represent the view of the Australian Institute of Company Directors.