Regardless of the size or type of company, directors have specific duties and obligations in carrying out their role. During uncertain times, those duties and obligations need additional attention and consideration. Directors therefore need to understand how their duties may develop and change when faced with financial distress and who they can turn to for expert advice.
Recent announcements by the Government has introduced temporary changes to the operation of insolvent trading laws as a result of the COVID-19 pandemic, however, these do not remove all risks from directors during the current period of financial distress.
Directors’ obligations and duties apply equally to volunteer directors of not-for-profit companies, to operators of small companies, as well as professional board members of listed entities – the key takeaway is be aware of your duties and seek timely advice from an expert.
Who do directors owe duties to?
Firstly, let’s consider who the directors owe duties to.
Generally, directors owe duties to the company rather than to individual shareholders, employees or to other stakeholders. The obligation of the company directors is decribed as requiring them to act in ‘the best interests of the company as a whole’.
However, in certain circumstances, the scope of the duties broadens to include an obligation to take into account the interests of creditors and to refrain from taking steps which may be adverse to creditors’ interests.
In periods of financial uncertainty, it becomes more important for directors to understand the financial position of the company and assess whether it can pay its debts as and when they become due and payable. If a company is unable to meet this obligation it is not solvent and likely to be insolvent.
This will mean that directors need to consider the impact of their decisions on creditors or potential creditors of the company when assessing whether a particular action is in the best interest of the company.
Consideration of creditors’ position
There is not a single standard requirement for what steps need to be taken to consider creditors’ interest in times of financial distress or insolvency of the company, but case law indicates directors must:
- give increased and proper consideration to creditors
- not favour one group of creditors over another, and
- not act in a way which prejudices the interests of creditors.
Concern over solvency
When should directors have concerns over the solvency of their company?
If your company is showing signs of financial distress, it’s crucial to determine if it’s insolvent. Insolvency is defined as the point when you can’t pay your debts as and when they fall due.
Importantly, the legal definition of insolvency focuses on a cash-flow test. However, the company’s balance sheet, available assets and the commercial realities play a part in considering what resources (including external sources of funding) may be available to a company to meet its debts when they are due.
Insolvency is characterised by an ’endemic shortage of working capital’ which is distinct from temporary cash flow challenges. While it’s likely that cash flow has been adversely impacted by the current economic challenges, it’s important to take early steps to ensure that it doesn’t result in an endemic shortage of working capital which cannot be overcome resulting in a formal insolvency appointment.
The determination of insolvency at a point in time can be a challenging assessment. It requires a careful and honest assessment of a company’s financial position, taken as a whole. It needs to cover debts which are currently due and those which may fall due in the near future.
If a company is on the brink of insolvency the directors need to take action immediately for two reasons:
- If they act quickly, they may be able to save the company or, at the very least, minimise the consequences.
Ordinarily, if they continue to trade while it is insolvent, they could be breaking the law, however temporary relief has recently been implemented for this (see below). Insolvent trading is a criminal offence which may impact their personal financial position.
If a director has concerns over the solvency of their company, they should act quickly to review the company’s financial position and seek professional advice from a properly qualified Registered Liquidator or a specialist insolvency lawyer.
Temporary relief for financially distressed businesses
On 22 March 2020, the Government announced (and continues to announce) measures to assist businesses with the impact of the current economic conditions. One of these measures includes temporary relief for directors from any personal liability for trading while insolvent.
Directors have been given 6 months relief from their duty to prevent insolvent trading to ensure companies have confidence to continue to trade through the current crisis, with the aim of returning to viability once it has passed.
The relief only relates to debts incurred in the ordinary course of business - one that is necessary to facilitate the continuation of the business during the six-month period, including new borrowings – and does not impact the requirement to pay the debts incurred. There are specific exclusions for dishonest and fraudulent activities.
It’s important to understand that this is a temporary measure to relieve the pressure directors may feel to make quick decisions to enter a formal insolvency appointment in the current uncertain environment. They do not alter the other duties owed by the directors nor the underlying financial position or long-term viability of the business.
Despite the relief offered, directors need to determine if the business is suffering from temporary liquidity challenges or an endemic shortage of working capital and consider their longer-term options.
Safe harbour protection for restructuring
As well as the temporary relief outlined above, safe harbour protection gives directors the opportunity to restructure their business outside of a formal insolvency appointment, with protection for directors from insolvent trading offences should the restructuring be unsuccessful, and the company end up in liquidation. Safe harbour offers protection beyond the 6-month period covered by the temporary relief.
Directors remain in control of the company throughout this process and the restructuring adviser works for the company and assists the directors.
There are important steps directors must take to protect themselves under safe harbour as well as giving the company the best chance to recover:
- Financial records in order
Directors can’t claim the protection of a safe harbour unless the company’s books and records are in order. This is vital because unless directors know where the company’s money is coming from and going to, there cannot be a plan to restructure the business. It’s also vital to understand where the company’s debts may be and how much is really owed, including tax debts, and this is important in understanding if the business is actually viable.
The company must have also complied with its obligation to pay its employees (including their superannuation) and its tax reporting obligations.
Compliance with tax reporting obligations is also necessary to ensure your clients have access to any cash flow assistance which may be available, noting that the ‘Cash flow assistance for business’ payment is tied to the ongoing lodgement of activity statements.
The law requires that directors get advice from an appropriately qualified adviser. The sooner expert advice is sought, the more options there are likely to be. While the law does not prescribe who this adviser should be, an ARITA Professional Member will be qualified to provide the needed advice.
- Develop and implement a restructuring plan for the company
Any restructuring plan must be properly documented - not just for directors to ensure that they are following the plan, but also if the turnaround doesn’t work, this gives a future liquidator comfort that the steps taken by directors, even if they failed, had merit and the right intent and it will help make sure directors are protected.
A restructuring plan doesn’t need to be long or complex. As long as it has clear and sensible steps to getting the business back to financial health and, importantly, that it is followed.
- Properly informed of the company’s financial position
The law requires directors to decide if the restructuring plan is ‘reasonably likely to lead to a better outcome for the company and the company’s creditors than if it had entered into voluntary administration or liquidation’. And that’s where the advice from a properly qualified professional is vital. The safe harbour protection only extends to debts incurred directly or indirectly in connection with the course of action or its development.
Differences for SMEs, large companies & not-for-profits
The law does not distinguish the treatment of financial distress between different sizes of companies or even if they are a not-for-profit.
In a practical sense, the main difference is the size of the response to distress. Engaging a restructuring or insolvency professional doesn’t need to be onerously expensive if the company is a not-for-profit. Indeed, the majority of insolvency and turnaround professionals work in small firms themselves.
Where to from here?
There are good options to help companies and directors through financial distress. But expert advice is key – an ARITA Professional Member can be part of the solution.
This material is not intended to constitute legal, business or other professional advice but is for information only. It is not intended as a substitute for advice from a qualified professional.
Federal and State Governments continue to update relief and assistance measures and you should refer to Government websites for up to date information. Further information is also available at www.arita.com.au.