Safe harbour from insolvent trading

Interview and podcast on the safe harbour from insolvent trading

Updated June 2020

Summary

  • Section 588G of the Corporations Act prohibits companies from trading while insolvent, and provides a cause of action for liquidators against company directors
  • Insolvency means that the company is not just experiencing a temporary liquidity problem but has a shortage of working capital, the company is unable to pay its debts as and when they fall due and payable
  • In order to comply with this requirement, directors had to move to external administration as soon as their company became insolvent to avoid personal liability
  • In September 2017, section 588GA was inserted into the Corporations Act
  • It stipulates that where a company directors suspects insolvency and incurs debts, but those debts are incurred in pursuit of a course of action that is reasonably likely to lead to a better outcome for the company, they shall not be liable under section 588G
  • This is not a defence, but a ‘carve out’: liquidators will have no claim against directors sheltering in the safe harbour
  • In March 2020, the safe harbour was extended to apply to more businesses, for more time, in recognition of the economic impact of COVID-19

Article Index

  1. What is the safe harbour from insolvent trading?
  2. COVID-19 Temporary Safe Harbour
  3. Key takeaways for businesses insolvent due to COVID-19
  4. Interview about obtaining the safe harbour provisions (2018)
  5. Podcast on the nature of the safe harbour provisions (2018)
  6. September 2017 Safe Harbour Provisions
  7. What is the prohibition on insolvent trading?
  8. Implementing a plan
  9. The hurdles to obtaining the safe harbour provisions
  10. Phoenix activity
  11. Alternatives to using the safe harbour provisions
  12. September 2017 Safe Harbour Summarised

What is the safe harbour from insolvent trading?

The safe harbour is a pro-business mechanism which helps companies stay afloat by giving directors protection from prosecution for insolvent trading while they work on a restructure. This means that companies that become insolvent can continue to trade, take out loans, and make changes aimed to restructure and revive the business, rather than immediately writing it off as a failure and instigating a formal appointment of a liquidator or voluntary administrator. It recognises the need for businesses to be given a ‘second chance’ to try a different approach and address their profitability.

The safe harbour is the only carve-out to the duty of company directors to cease trading when a company is insolvent. The safe harbour from insolvent trading as it was introduced in September of 2017 represents a significant watering down of the insolvent trading prohibition and is an alternative to a formal appointment of a voluntary administrator or liquidator. The extension of the safe harbour for COVID-19 provides even further allowances for companies seeking to survive the economic storm.

COVID-19 Temporary Safe Harbour

The new Coronavirus Economic Response Package Omnibus Act 2020 has just come into force to provide relief to businesses struggling due to COVID-19. One of the key changes is the addition of Section 588GAAA to the Corporations Act 2001 (the federal law governing companies). It provides a new, temporary ‘safe harbour’ from the prohibition on directors from trading while insolvent at Section 588G of the Corporations Act.

The safe harbour as it stood before COVID-19 was introduced in September 2017 to help company directors undertake informal company restructures during insolvency. The new COVID-19 provision, while operating on the same principle, is slightly differently in recognition of the new economic challenges presented by the COVID-19 recession.

This new safe harbour applies to protect directors from being held personally liable for trading while insolvent if:

  • The debt is incurred in the ordinary course of business;
  • The debt is incurred in the six-month period from 24 March 2020; and
  • The debt is incurred before the appointment of a voluntary administrator or liquidator.

While the new section does not define what constitutes the ‘ordinary course of business’, the Explanatory Memorandum suggests that this clause is limited to apply only to debts “necessary to facilitate the continuation of the business”, i.e. taking out a loan to move the business online or a debt to pay employees during the pandemic. It should be noted that this protection, designed specifically for COVID-19, is narrower than the existing regime which protects debts incurred directly or indirectly that ae likely to lead to better outcomes for the company. The advantage of the new, temporary scheme is its automatic operation for six months (although the evidential burden of proving compliance will lie with the directors seeking to use it).

So, what does this mean for directors? It allows them time and flexibility to invest in restructuring to suit the new economic and social conditions, rather than moving straight to a voluntary administration or liquidation appointment. Essentially, its good news – breathing space to consider the options.

Key takeaways for businesses insolvent due to COVID-19 in 2020

For directors concerned about whether their trading and debts during COVID-19 are covered by the new, temporary measures, consider the following:

  1. Is the debt necessary to facilitate the continuation of the business during and/or after the pandemic?
  2. Will the debt be incurred within six months of the section’s commencement (24 March 2020 – 24 September 2020) subject to extension by amendment?
  3. Has there not yet been a formal appointment of a voluntary administrator or liquidator?
  4. Can you (the director) provide evidence to prove that you have complied with the requirements of the safe harbour (i.e. statements, invoices, payroll, bank reconciliations, a written plan, professional advice, etc.)

Interview about obtaining the safe harbour provisions (2018)

See Ben Sewell of Sewell & Kettle Lawyers interviewed on the significance of the safe harbour.

In this interview, Ben outlines the provisions implemented in September 2017, how they can be utilised, what they mean for phoenix activity, and what the options are for directors.

Discussion includes:

  • The September 2017 safe harbour provisions
  • The prohibition on insolvent trading
  • Implementing a plan
  • The hurdles to obtaining the safe harbour provisions
  • Phoenix activity
  • Alternatives to the safe harbour provisions

Podcast on the nature of the safe harbour provisions

Listen to Ben Sewell of Sewell & Kettle Lawyers in this podcast for Tax Talks from 2018 with Heide Robson discussing the safe harbour provisions.

In this podcast, Ben will explain the September 2017 safe harbour provisions and how they compares to international insolvency protections, the difficulties and implications associated with implementation, and the role of professional advisers in the process.

Discussion includes:

  • Summary of the September 2017 reform
  • What is the prohibition on insolvent trading for company directors?
  • Rules, but no specific process for the safe harbour mandated
  • What is the “better outcome” test?
  • This is not a Chapter 11 reform but a step towards it
  • One size does not fit all
  • Key hurdle is tax return lodgement and payment of employee entitlements
  • Getting advice from an “appropriately qualified entity”
  • What is a solicitor’s potential role?
  • What is a turnaround plan?

Please click here to see Ben Sewell’s article on the safe harbour as it was published in the Law Society Journal in April 2018.

September 2017 Safe Harbour Provisions

  • There was an enormous change in insolvency law in Australia in 2017. The biggest reforms are a “carve-out” to the prohibition on insolvent trading. This means that, theoretically, companies can trade if they are unable to pay their debts, whereas before, they could not.
  • These reforms came about in September 2017 so there is little case law on it yet.
  • A “carve out” means that the new section 588GA has been added to the Corporations Act 2001 (Cth) which provides: “safe harbour – taking a course of action reasonably likely to lead to a better outcome for the company”

What is the prohibition on insolvent trading?

Prior to 2017, the law effectively mandated directors to move to external administration as soon as their company was insolvent to avoid the risk of personal liability. Under section 588G of the Corporations Act, there is a prohibition on anyone who is appointed a director of a company in Australia from continuing to trade – that is, incurring debt – if the company is insolvent. Insolvency means that the company is not just experiencing a temporary liquidity problem but has an endemic shortage of working capital. The company is therefore unable to pay its debts as and when they fall due and payable. Section 588G is a cause of action that liquidators had against company directors after a company is placed in liquidation.

These reforms were a dramatic departure from the previous insolvency law because previously, a director of an insolvent company would be automatically advised to make a formal appointment. This was because under the prohibition against insolvent tradition there was:

  • a duty to creditors; and
  • if the company went into liquidation, they may have to pay back all of the debts incurred while the company trades.

This has changed the game for professional advisors, lawyers and accountants because now there is a third path available: restructure through the safe harbour.

There is nothing specific in the legislation about the type of professional advisor required to advise the directors. This means that directors can also ‘self-help’. They can implement a plan to put themselves into a safe harbour.

The duty to prevent insolvent trading does not apply when:

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

Implementing a plan

In contrast to the US Chapter 11 requirements, in Australia directors do not need to go to court to get safe harbour protection at law. Section 588GA states that safe harbour starts when the company director starts to implement a plan. Section 588GA provides that the plan does not need to be finally executed but directors will need some evidence of what they have done for example a written plan or a minute of what is being proposed.

Any ‘appropriately qualified’ entity, being a lawyer, accountant, or a consultant is able to advise. The controversy in this is that term is very vague and the uncertainty about whether the ‘appropriately qualified’ entity bears the risk if they do not provide accurate or appropriate advice that a director follows. For example, do lawyers provide that advice in their capacity as a lawyer or as a consultant? There is no requirement that it has to be in its capacity as a lawyer.

It is the role of an insolvency lawyer to consider:

  • the personal risk to the directors;
  • the structure of the business;
  • whether there can be a restructure put in place; and
  • working with other stakeholders.

If a company director is utilising the safe harbour provisions, there is no legal requirement that they inform their creditors. Disclosing that a company has put itself in a safe harbour position may result in their debts being called in by creditors.

The only company to disclose that they were in safe harbour, was a mining company in 2018 and this was generally held by the industry to be a mistake as they had informed the ASX that they were in the safe harbour which was made publicly available.

The hurdles to obtaining the safe harbour provisions

The main hurdles in section 588GA are:

(1) all employee entitlements of the company need to be paid as they fall due; and
(2) all of the company’s tax returns need to be filed.

In the small to medium-sized enterprise space, when a company is approaching insolvency they normally:

  • stop preparing their tax returns;
  • engage in creative accounting; and
  • stop paying their superannuation or other employee entitlements.

If a company is not able to ensure that they are compliant, then they cannot take advantage of the safe harbour provisions. It is easier for large companies to comply with the hurdles because they have better processes and accounting support.

Phoenix activity

There is no definition in the Corporations Act of what phoenix activity is and there are no specific prohibitions on it.

One of the main characteristics of phoenix activity is that companies do not remit their PAYG tax to the Australian Tax Office. If you look into a phoenix, one of the issues is that the debts are left in one entity and the assets are transferred to another without any appropriate consideration being paid. This sort of activity may or may not mean that the company will fall short of one of the two hurdles in section 588GA.

These hurdles are an indirect way to try to stop the phoenix operators from engaging the safe harbour provisions. Another legal mechanism is the prohibition on creditor defeating dispositions.

Alternatives to the safe harbour provisions

The principle approach since 1993 is to appoint a voluntary administrator. The safe harbour provisions have the potential to decimate the appointment of voluntary administrators in Australia and encourage sensible risk taking.

Over a long period of time, there has been a decline in the formal insolvency profession in Australia. This is because we have not had a recession and that the banks have stopped making as many formal appointments. Now, if directors are able to put together a turnaround plan, they will not need to appoint one as long as they are complying with their employee entitlements, lodging their tax returns, and implementing a plan which is likely to lead to a better return or can later be explained to a court.

Growth in the insolvency industry is largely restricted to the phoenix activity space and its prosecution.

There is a low chance that a director will be sued for insolvent trading, especially in a small to medium-sized enterprise. In fact, it has been said that “you have a greater chance in Australia of being bitten by a shark in George Street than being sued for insolvent trading”.

One empirical study, Insolvent Trading – an empirical study conducted by Paul James, Professor Ian Ramsay and Polat Siva found that there were only 63 insolvent trading judgments in Australia between the 1960s and 2004. For a liquidator to run an insolvent trading claim, it is a demanding and expensive exercise so they are usually averse to this course.

September 2017 Safe Harbour Summarised

  • In summary, section 588GA says that if you are a director of a company and that company is insolvent, being unable to pay its debts, if the director starts to put together a plan that has a chance of putting the company in a better position than it would have been compared to liquidation or voluntary administration, that plan can be implemented and the company turned around, the directors will not have to worry about the prohibition on insolvent trading.
  • The reforms came about due to policy makers deciding that the previous prohibition on insolvent trading operated to discourage company directors from taking sensible risks when considering an informal workout as an alternative to voluntary administration.
  • Some parts of the profession had wanted to make these new reforms a defence so that the liquidator could commence proceedings against a director. However, the new insolvency laws are not a defence to directors insolvent trading. Under the carve out reforms, the liquidators do not even have a claim.
  • The reforms apply to both big and small companies. One of the characteristics of small-medium sized enterprises is that owners are often also directors whereas big enterprises will have independent directors.
  • One of the disadvantages of these reforms is that there is a real risk that the plan will not be successful and that the turnaround will actually result in the asset value diminishing and not increasing. There is a real risk for creditors who may be put in a worse position by the safe harbour than if the company had immediately been put into liquidation or voluntary administration.
  • There is, therefore, a risk to creditors and stakeholders by the implementation of these provisions as they are vague, laissez-faire and do not encourage sensible risk and may even encourage directors to take risks adverse to the creditors and stakeholders.

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