In September 2017, Australia’s insolvent trading laws were significantly watered down by the introduction of a new safe harbour for directors. Ben Sewell of Sewell & Kettle Lawyers explains the significance of the new law.
- The new 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
The new safe harbour provisions
- There has been enormous change in insolvency law in Australia. 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 no case law on them yet.
- A “carve out” means that the new section 588GA has been added to the Corporations Act 2001 (Cth) which provides: “safe harbour – taking course of action reasonably likely to lead to a better outcome for the company”
(1) Subsection 588G(2) does not apply in relation to a person and a debt if:
(a) at a particular time after the person starts to suspect the company may become or be insolvent, the person starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company; and
(b) the debt is incurred directly or indirectly in connection with any such course of action during the period starting at that time, and ending at the earliest of any of the following times:
(i) if the person fails to take any such course of action within a reasonable period after that time–the end of that reasonable period ;
(ii) when the person ceases to take any such course of action;
(iii) when any such course of action ceases to be reasonably likely to lead to a better outcome for the company;
(iv) the appointment of an administrator, or liquidator, of the company.
Note 1: The person bears an evidential burden in relation to the matter in this subsection (see subsection (3)).
Note 2: For subsection (1) to be available, certain matters must be being done or be done (see subsections (4) and (5)).
Working out whether a course of action is reasonably likely to lead to a better outcome
(2) For the purposes of (but without limiting) subsection (1), in working out whether a course of action is reasonably likely to lead to a better outcome for the company, regard may be had to whether the person:
(a) is properly informing himself or herself of the company’s financial position; or
(b) is taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay all its debts; or
(c) is taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company; or
(d) is obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice; or
(e) is developing or implementing a plan for restructuring the company to improve its financial position.
(3) A person who wishes to rely on subsection (1) in a proceeding for, or relating to, a contravention of subsection 588G(2) bears an evidential burden in relation to that matter.
Matters that must be being done or be done
(4) Subsection (1) does not apply in relation to a person and a debt if:
(a) when the debt is incurred, the company is failing to do one or more of the following matters:
(i) pay the entitlements of its employees by the time they fall due;
(ii) give returns, notices, statements, applications or other documents as required by taxation laws (within the meaning of the Income Tax Assessment Act 1997 ); and
(b) that failure:
(i) amounts to less than substantial compliance with the matter concerned; or
(ii) is one of 2 or more failures by the company to do any or all of those matters during the 12 month period ending when the debt is incurred;
unless an order applying to the person and that failure is in force under subsection (6).
Note: Employee entitlements are defined in subsection 596AA(2) and include superannuation contributions payable by the company.
(5) Subsection (1) is taken never to have applied in relation to a person and a debt if:
(a) after the debt is incurred, the person fails to comply with paragraph 429(2)(b), or subsection 475(1), 497(4) or 530A(1), in relation to the company; and
(b) that failure amounts to less than substantial compliance with the provision concerned;
unless an order applying to the person and that failure is in force under subsection (6).
(6) The Court may order that subsection (4) or (5) does not apply to a person and one or more failures if:
(a) the Court is satisfied that the failures were due to exceptional circumstances or that it is otherwise in the interests of justice to make the order; and
(b) an application for the order is made by the person.
(7) In this section:
“better outcome” , for the company, means an outcome that is better for the company than the immediate appointment of an administrator, or liquidator, of the company.
“evidential burden” , in relation to a matter, means the burden of adducing or pointing to evidence that suggests a reasonable possibility that the matter exists or does not exist.
- 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 a 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.
The prohibition on insolvent trading
Previously, the law effectively mandated directors to move to external administration as soon as their company was insolvent to avoid 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 at the time. 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. Section 588G was a cause of action that liquidators had against company directors after a company is placed in liquidation.
These new reforms are a dramatic departure from the previous insolvency law because before the safe harbour carve out was created. Previously, a director of an insolvent company went to see a professional advisor who would advise on a formal appointment. This was because, under the prohibition against insolvent tradition there was:
This has changed the game for professional advisors, lawyers and accountants because now there is a third path available.
There is nothing specific in the legislation about the type of professional advisor required to advise the directors. This means that directors can ‘self-help’. They can implement a plan to put themselves into a safe harbour.
Now, the duty to prevent insolvent trading does not apply when:
(i) 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
(ii) 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. Section 588GA specifically states that the safe harbour starts when the company director starts to implement a plan. Section 588GA says 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 a 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 their capacity as a lawyer. The lawyer negligence would apply to what ever advice was given. There is no case law about this yet.
Under the safe harbour protection, the director has the legal obligation. If directors seek the advice of a law or accounting firm as to whether they are insolvent, they generally are insolvent. It is the role of an insolvency lawyer to:
- look at the personal risk to the directors;
- the structure of the business;
- whether there can be a restructure put in place;
- to work with other stakeholders; and
- to look at other issues such as whether employee entitlements are being paid.
If a company director is utilising the safe harbour provisions, there is no legal requirement that they inform their creditors. It may not be a good idea to disclose that that a company has put itself in a safe harbour position as their debts could be called in if they do disclose it.
The only company to disclose that they were in safe harbour, was a mining company last year 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 is that:
(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
- possibly engaging in creative accounting
- stop paying their superannuation or other employee entitlements
Now, if a company is not able to ensure that they are up to date in these regards, then they cannot take advantage of the safe harbour provisions. It would be easier for larger companies to implement the provisions as they have better processes to comply with these requirements. Also, their directors are independent and do not have any incentive to not pay their employee entitlements.
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 will likely mean that the company will fall short of one of the two hurdles in section 588GA.
These hurdles may be an indirect way to try to stop the phoenix operators from engaging the safe harbour provisions.
Alternatives to the safe harbour provisions
The principle approach since 1993 is to appoint a voluntary administrator. The new provisions have the potential to decimate the appointment of voluntary administrators in Australia.
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 restricted to the phoenix activity space.
One reform is related to creating an ecosystem of entrepreneurship. The period of undischarged bankruptcy is going to go down from three years to one year to try and encourage entrepreneurship.
The second reform will result in counter parties to contracts not having the right to terminate whilst the company is in voluntary administration.
There is 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 adverse to this course.