Insolvency Revolution for SMEs: Australia’s new ‘debtor in possession’ restructuring procedure

Estimated reading time: 9 minutes

The Government is using its currently massive political capital to push through a revolution in SME insolvency law in Australia. Their aim is to make the insolvency process less draconian for small businesses and, in the long term, encourage a more entrepreneurial culture. The changes foreshadow streamlined and genuine debt forgiveness outside of voluntary administration.

Insolvency Revolution for SMEs

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It was announced that the Commonwealth Government will introduce a new ‘debtor in possession’ restructuring framework for distressed businesses, as opposed to the current ‘creditor in possession’ options of voluntary administration and liquidation. At first glance, this looks like a promising new option for struggling businesses to avoid voluntary administration and liquidation, an outcome that is all but inevitable when temporary insolvency protections for businesses end on 31 December 2020. Given the dismal success rate of voluntary administrations, and the poor returns they provide for creditors, it is an outcome to be avoided. 

In this update we explain:

  • What the new restructuring framework looks like;
  • How this differs from existing ‘safe harbour’ protections under the Corporations Act 2001 (Cth); and
  • How the proposed Australian framework differs from the ‘Chapter 11’ bankruptcy process in the United States.

What will the new restructuring framework look like?

The Government has not yet released detailed information on what the process will look like, so our comments here are preliminary and subject to change. However, in the briefing materials they have provided thus far, the Government sets out the key elements of the new framework. The restructuring framework will involve a prescribed process with two stages.

Stage One: Preparing the restructuring plan

  • Companies that are “distressed” and owe less than $1 million will be able to appoint a new type of professional, a ‘small business restructuring practitioner’ (SBRP). This individual will oversee the development of a ‘restructuring plan’. While the Government has yet to set out what will count as a “distressed” corporation, it is likely that this will include insolvent businesses, i.e. companies that are presently unable to pay their debts as they fall due and payable;
  • Once appointed, the SBRP will send a notice to all creditors setting out what the process will involve, and how they will have access to ongoing information;
  • The company will be able to continue trading, even where insolvent, while the debt restructuring plan is developed. There will be 20 days to develop that plan;
  • While the plan is being developed, there will be a moratorium on unsecured (and some secured) creditors taking legal action to recover their debts; and
  • If satisfied with the plan, the SBRP will ‘certify’ it, and submit it to the creditors for consideration.

Stage Two: Approving the restructuring plan

  • The debt restructuring plan will then be voted on by creditors. They will have 15 business days to conduct the vote. Any employee entitlements that are due and payable must be paid out before the plan is put to a vote. To be approved, creditors accounting for at least 50% of the value of outstanding debts must vote in favour of the plan;
  • While voting on the restructuring plan, creditors will also be required to approve the SBRP’s remuneration and expenses;
  • If the plan is approved, creditors will relinquish their right to pursue existing debts against the business. The SBRP will be responsible for overseeing disbursements to creditors in accordance with the restructuring plan; and
  • If the plan is unsuccessful, and the company is insolvent, the company will be eligible to go into voluntary administration, or a new streamlined liquidation process. This new liquidation process will have reduced requirements for creditor’s meetings and reporting.

There will be several features built into the new restructuring framework to prevent its misuse, including by potential “phoenix operators”. These proposed measures include:

  • A ban on “related creditors” voting on the restructuring plan;
  • Companies and directors will not be able to use the process more than once in a given timeframe. It has been indicated that this timeframe will be seven years; and
  • A power to stop the process if deliberate misconduct is identified. It is not clear yet who will carry out this process (it may be the Court).

It is proposed that the new restructuring framework will come into effect on 1 January 2021 to coincide with the end of temporary protections (31 December 2020) for businesses brought in to counter the economic impact of COVID-19. This is a momentous event in insolvency law and the insolvency industry now has very little time to pivot their strategy and offerings to fit within the new regime.

What existing arrangements are there in Australia for distressed companies to restructure?

Under section 588G of the Corporations Act 2001 (Cth), directors of companies have a duty not to allow their company to trade while insolvent. Up until 2017, if a company was insolvent, it was required that a voluntary administrator or a liquidator be appointed. This usually meant the end of that business as a going concern.

Since 2017, under section 588GA of the Corporations Act 2001 (Cth) there has been a ‘safe harbour’ from insolvent trading in place (the ‘standard safe harbour’). The standard safe harbour means that directors are not in breach of their duty to prevent insolvent trading where:

  • At a particular time after the director suspects insolvency, the director develops a course of action that is reasonably likely to lead to a better outcome for the company; and
  • Debts are incurred in connection with the course of action.

While developing this ‘course of action’, directors are required to:

  • Take action to prevent misconduct by officers and employees of the company;
  • Keep accurate books and records of the company;
  • Receive advice from an ‘appropriately qualified entity’;
  • Continue paying/providing employee entitlements (such as superannuation); and
  • Continue complying with tax reporting obligations.

The standard safe harbour should not be confused with the current, temporary, ‘COVID-19 safe harbour’. Section 588GAAA of the Corporations Act 2001 (Cth) provides that directors will not be in breach of the duty to prevent insolvent trading if:

  • The debt is incurred in the ordinary course of business;
  • The debt is incurred up until 31 December 2020;
  • The debt is incurred before the appointment of the voluntary administrator or liquidator.

Note that once the new restructuring framework comes into effect (predicted to be on 1 January 2021), this temporary safe harbour will no longer be available.

What is the difference between the new restructuring framework and the standard safe harbour?

There are some superficial similarities between the standard safe harbour and the new restructuring framework, however, there are also some key differences:

  • The requirement to consult an ‘appropriately qualified entity’ as part of the safe harbour is vague and undefined, and arguably leaves some directors unsure about whether they have satisfied the legal requirements. By contrast, the new role of the SBRP is (or will be) clearly defined;
  • There are requirements of ‘form’, and creditor notification requirements, for the new restructuring framework. By contrast, developing a ‘course of action’ under the standard safe harbour can happen in relative secrecy and has no prescribed form;
  • There is a clear time limit on the new restructuring framework (20 days to develop the plan). By contrast a ‘course of action’ under the standard safe harbour has no official time limit and could drag on for months;
  • Creditors must agree to a restructuring plan; and
  • Under the new restructuring framework, there is a moratorium on creditor proceedings, while under the standard safe harbour, creditors could still bring court proceedings at their discretion.

How does the new restructuring framework compare to ‘Chapter 11’ in the USA?

The new restructuring framework mirrors aspects of the restructuring framework proposed in the  Productivity Commission’s 2015 report Business Set-Up, Transfer and Closure. It also has similarities with existing ‘debtor in possession’ restructuring models overseas. For example, in Canada, the Companies’ Creditors Arrangement Act provides for a Court-supervised restructuring process that gives companies time to develop a ‘Plan of Compromise or Arrangement’ which would settle creditor claims.

Perhaps the most famous ‘debtor in possession’ approach is the ‘Chapter 11’ bankruptcy process in the United States (officially, ‘Title 11, U.S. Bankruptcy Code’).

While there are some surface similarities, it is worth noting several key differences between Chapter 11 and Australia’s new restructuring framework:

  • Chapter 11 is a formal insolvency process overseen by the Court. Australia’s new restructuring process will be overseen by a new type of practitioner, the SBRP;
  • While a Chapter 11 process is in motion, there are limits on what a business can do without the permission of the Court. For example, they cannot sell assets (other than inventory), or start or terminate rental agreements. Australia’s new restructuring framework has no such limitations;
  • The directors during a Chapter 11 process have 120 days to propose a restructuring plan for approval of the Court. After that date, others (such as creditors) can propose their own plan. Under Australia’s new restructuring framework there will be 20 days to develop the restructuring plan; and
  • With the permission of the court, Chapter 11 allows for ‘debtor in possession’ financing. This financing, offered to support re-organisation efforts, has priority under the law over existing unsecured creditors. There is currently no indication that rescue finance will get priority in Australia’s new restructuring framework (though this could change as the proposals are further developed or more detail is released).

Conclusion

There have been suggestions that Australia should develop a ‘debtor in possession’ restructuring framework for a long time. It is clear that something must be done to prevent a tsunami of insolvent voluntary administrations and liquidations when temporary COVID-19 protections end. While the new restructuring framework appears promising, there are several questions that remain, and may be answered as further policy detail is released:

  • Who will be eligible to become a SBRP? What will their required qualifications be?
  • Will there be any priority given to ‘rescue’ financing during the restructuring process, as is permitted in Singapore and the United States?
  • What will the new streamlined liquidation process look like?
  • How will the new restructuring framework interact with the existing ability to develop a ‘course of action’ under the standard safe harbour in section 588GA of the Corporations Act 2001 (Cth)? Will directors be able to pick and choose between both types of restructure?
  • Will there be a quorum for the creditor vote, and if this is not reached with the SBRP have a casting vote?
  • Will the debt compromise also bind secured creditors?

On a strategic level, it is worth remembering that every revolution in history is followed by a counter-revolution. The push back from this regime change is likely to be strong and the key limit (employee entitlements being paid in full) will make the new regime difficult for most small businesses. Australia has also retained its industrial democracy model (creditor vote) and it has not considered an alternative with a Court application to approve of the debt forgiveness proposal.

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Insolvency Revolution for SMEs

Insolvency Revolution for SMEs: Australia’s new ‘debtor in possession’ restructuring procedure

Estimated reading time: 9 minutes

The Government is using its currently massive political capital to push through a revolution in SME insolvency law in Australia. Their aim is to make the insolvency process less draconian for small businesses and, in the long term, encourage a more entrepreneurial culture. The changes foreshadow streamlined and genuine debt forgiveness outside of voluntary administration.