The Australian Institute of Company Directors (AICD) has long advocated for insolvency reforms to promote a culture of entrepreneurship and innovation and encourage company directors to engage early with financial hardship and take reasonable risks to facilitate a company’s recovery.

The government has responded to directors’ concerns, releasing draft legislation which, if enacted, would amend the Corporations Act 2001 (Corporations Act) to create a ‘safe harbour’ for company directors from personal liability for insolvent trading if the company is undertaking a restructure in certain circumstances.

The amendments would also make ‘ipso facto’ clauses unenforceable if a company has entered into a formal insolvency process. Currently, ‘ipso facto’ clauses allow contracts to be terminated or unilaterally amended solely due to an insolvency event. The aim of this reform is to prevent these types of clauses from reducing the scope for a successful restructure or preventing the sale of the business as a going concern.

The government hopes that these changes will drive cultural change amongst company directors by encouraging them to engage early with financial hardship, keep control of their company and take reasonable risks to facilitate the company’s recovery instead of placing the company prematurely into voluntary administration or liquidation.

How would the proposed safe harbour work?

Unfortunately, some commentators appear to have misconstrued how the safe harbour works in practice.

Under the government’s proposed legislation, the safe harbour is essentially drafted as a defence, or in a layperson’s terms, a rebuttal to the civil insolvent trading provisions in the Corporations Act. Strictly speaking, it is neither a ‘carve out’ or an ‘exception’, though the government describes it as such in its draft Explanatory Memorandum.

Directors of companies in distress or insolvency situations can rely on the safe harbour protection if they commence a ‘course of action’ which was 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, or ceases to be reasonably likely to lead to a better outcome, or the company is placed into Chapter 5 administration, the safe harbour ends.

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’.

In other words, company directors would be protected by the safe harbour if they formulate and implement a course of action in order to improve the company’s position, and their chosen course of action is reasonably likely to lead to a better outcome when compared with the outcome which would likely follow should they placing the company into formal administration under Chapter 5 of the Corporations Act.

If a director’s decision to undertake a course of action was ever challenged by the Court, it would be assessed by the Court objectively. That means that the Court will not examine what a director believed would be a better outcome.

In a litigation scenario, the impugned director would need to show hard evidence suggesting a reasonable possibility existed that a better outcome would result from their chosen course of action.

Directors are given some assistance by the proposed model in determining whether a course of action would be ‘reasonably likely’ to lead to better outcome:

  • The legislation proposes a set of ‘relevant factors’ to help a director to determine whether a course of action would be reasonably likely to lead to a better outcome. These include whether a director ‘is properly informing himself or herself of the company’s financial position’, ‘obtaining appropriate advice’ and ‘developing or implementing a plan for restructuring the company’; and
  • The defence only imposes an evidentiary burden on directors. This means that directors would only need to adduce or point to evidence that ‘suggests a reasonable possibility’ that the outcome was reasonably likely to lead to a better outcome. This is the lowest burden of proof in the law.

AICD concerns

The AICD has some concerns with the proposed safe harbour reforms. Key concerns we have identified include the following:

  • 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 these challenges.
  • In conducting the counterfactual analysis required by the ED Safe Harbour, 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 phrase is ambiguous, departs from the current law relating to directors’ duties, and may even modify directors’ duties in the general law.

The AICD has made a submission to the government in relation to the proposed legislation. Our submission has suggested changes to the legislation so the safe harbour will be useful and workable in practice, and can be viewed here. We expect that legislation will be introduced into parliament sometime this year.

Hear more about the proposed ‘safe harbour’ reforms from AICD Senior Policy Adviser Lysarne Pelling on the AICD’s economics podcast, The Dismal Science.