Navigating the safe harbour: The role of solicitors (Trading while insolvent)

Navigating the safe harbour: The role of solicitors

By Ben Sewell of Sewell & Kettle Lawyers

Snapshot

  • The new safe harbour from trading while insolvent is the most significant change to corporate insolvency law since the introduction of voluntary administration in 1993
  • The government enacted a more laissez-faire model for the safe harbour protection than the model proposed by the Productivity Commission
  • Helping directors of small-to-medium-sized enterprises to obtain safe harbour protection represents an exciting opportunity for solicitors when previously, insolvent companies were mandated to commence external administration

Background: Watering down of the insolvent trading prohibition

Australia’s prohibition on companies trading whilst insolvent (section 588G of the Corporations Act) has had a long history of being criticised. Australia, formerly, had the strictest insolvent trading prohibition in the developed world (Hon Martin CJ, 2009 IP Conference 28 May 2009). No other developed country prohibited companies from incurring debts whilst insolvent thereby mandating commencement of formal insolvency proceedings (Harris, Jason ‘Director Liability for Insolvent Trading: Is the cure worse than the disease?’ (2009) Australian Journal of Corporate Law, Vol. 23, No. 3).

Under the prohibition, a director of a company may become personally liable for debts incurred by a company whilst it is insolvent. Broadly, section 588G provides that a director will be found to have breached their duty if:

  • The person was a director at the relevant time;
  • The company was actually insolvent;
  • The company incurred a debt; and
  • There were reasonable grounds for the director to suspect insolvency.

The penalties for a director breaching the prohibition include:

  • Civil penalties of up to $200,000 (sections 1317E and 1317G);
  • Liability to compensate the company or relevant creditor for the amount of the debt incurred as a result of the breach (section 588M); and
  • Criminal prosecution in limited circumstances (section 1311, Schedule 3 Item 138).

The key issue that policy-makers sought to address was that there was no defence to trading while insolvent even when a director recognised the financial problems faced by their company but incurred debts during an attempt to turnaround the business as an alternative to formal insolvency proceedings (such as liquidation or voluntary administration). The direction of policy-makers was to consider how to encourage appropriate informal work-outs and the solution was the new safe harbour protection.

The most important report that recommended a safe harbour from trading while insolvent was the Productivity Commission’s Business Set-up, Transfer and Closure (No 75, 30 September 2015). The Productivity Commission’s recommendations, however, were not followed by the government. The Commission recommended that a registered “Restructuring Adviser” take carriage of the safe harbour process and that they follow a set process that included providing a certificate. Under the Productivity Commission model, the Restructuring Adviser was also required to have a deep knowledge of insolvency (see recommendation 14.2, page 387). Instead, the government inserted a new section 588GA into the Corporations Act that, compared to the Productivity Commission recommendations, is vague and laissez-faire. The substantial requirements to obtain safe harbour protection include starting to “develop” a course of action for a turnaround and meeting a threshold of filing tax returns on time and paying all employee’s entitlements in full.

One step towards Chapter 11: The new safe harbour from insolvent trading

In September of 2017, the new safe harbour amendments to the Corporations Act were given royal assent and are current law. The amendment provides that the duty to prevent trading while insolvent will not apply when:

  • 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
  • The company debt is incurred in connection with the course of action.

It must be remembered that the safe harbour is not a defence but it is a carve-out from the principal cause of action. It must, therefore, be considered by liquidators before they undertake a claim for trading while insolvent.

To claim the safe harbour protection there is no specific process that is mandated for a director to undertake and it is dependent on the size and complexity of the company’s circumstances. But the new law includes indicators about what a course of action may involve, including the director (and therefore the board):

  • Informing themselves about the company’s financial position;
  • Taking steps to prevent misconduct by officers and employees;
  • Keeping appropriate books and records;
  • Obtaining advice from an “appropriately qualified entity”; and
  • Developing or implementing a plan for restructuring the company.

The key test to be considered is whether the course of action developed may be “reasonably likely to lead to a better outcome for the company” (section 588GA(1)(a)). A “better outcome” is compared to what would occur if there was to be an immediate appointment of a voluntary administrator or liquidator over the company.

The foundation of the Australian insolvency regime, in contrast to Chapter 11 of the United States Bankruptcy Code, is that independent experts are appointed as liquidators, voluntary administrators or receivers to insolvent companies. Under Chapter 11 there is a debtor-in-possession regime, wherewith Court approval, the directors of companies remain in control of the company whilst having the benefit of a moratorium from creditor action. The safe harbour is a step towards Chapter 11 because the directors can continue to trade during insolvency whilst undertaking a restructuring process.

Critically, under the new safe harbour, there is no penalty for directors utilising assets, whilst in safe harbour, that would have been available to satisfy creditor claims had a liquidator or voluntary administrator been appointed. One opponent of the safe harbour has also argued that it could shield directors whilst they undertake phoenix activity (Anderson, Helen ‘Shelter from the storm: Phoenix activity and the safe harbour’ (2018) Melbourne University Law Review 41(3)).

The same law, different behaviours: Large corporates versus SMEs

One criticism of corporate insolvency law in Australia is that the same law applies to large corporates (greater than 200 employees) and to small-to-medium sized enterprises (SMEs) (less than 200 employees) while the problems they face and their response to insolvency is significantly different. Large corporates have independent directors who don’t have their assets substantially tied up in the business and they have access to sophisticated professional advisers. On the other hand, SMEs are owned by their directors and are unlikely to have ready access to sophisticated professional advisers. SME directors have “skin in the game” and it is more than likely that their personal asset position is intrinsically linked to their company through personal guarantees.

The result is that SME directors are more likely than directors from large corporates to take a risk (both good and bad risk) when their company is facing insolvency. This is an important consideration for solicitors advising directors facing insolvency because a careful reading of section 588GA should be undertaken before advising a client about whether they have the right to claim the safe harbour. Directors of SMEs may be tempted to breach their duties when facing insolvency by undertaking phoenix activity (see ASIC v Somerville & Ors [2009] NSWSC 934 for an example of a solicitor being found to have accessorial liability for phoenix activity).

Key hurdle: Tax returns and payment of employee entitlements

Phoenix activity is a concern for regulators and so lodging tax returns and paying employee entitlements is a threshold requirement for the new safe harbour. The specific requirements are set out in section 588GA(4) under the heading ‘Matters that must be being done or be done’.

Further, if a company goes into liquidation after a safe harbour period and the directors do not co-operate with the liquidator they will retrospectively lose the safe harbour protection. Books and records that the director relies upon may not be admissible to support a claim for safe harbour protection. This obligation is set out in section 588GB and it applies if directors fail to meet their obligations to supply books and records to liquidators.

Qualifications of solicitors to be an “appropriately qualified entity”

One of the indicators of whether a director has a claim for safe harbour protection is whether they have obtained advice from an “appropriately qualified entity” (section 588GA(2)(d)). There isn’t much guidance on who this person may be but it certainly includes solicitors. The Explanatory Memorandum (Treasury Laws Amendment (2017 Enterprise Incentives No 2 Bill) explains:

1.35 The factors in subsection 588GA(2) therefore provide only a guide as to the steps a director may consider or take depending on the circumstances. For example, a small business may only need to seek the advice of an accountant, lawyer or another professional, while a large listed entity might retain an entire team of turnaround specialists, insolvency practitioners, and law and accounting firms to advise on a reasonable course of action.

The conclusion, certainly, is that an experienced solicitor may be an “appropriately qualified entity” to advise SME directors on safe harbour protection.

Elements of the solicitor’s potential role

The new safe harbour protection is not a defence to the trading while insolvent prohibition but it is a carve-out that requires professional interpretation. This opens up an opportunity for solicitors to advise clients and evaluate any “course of action” that is developed. For example, to obtain safe harbour protection there is no strict requirement to execute a turnaround plan but only to start to “develop” one. This means that if a prudent solicitor finds that the company is better off being liquidated the director may claim the safe harbour whilst this course of action is being “developed”. Solicitors should note that under section 588GA(1)(b)(i) the safe harbour protection will end if the course of action that is developed is not undertaken “within a reasonable time”.

The take-away for solicitors should be to apply common sense and provide advice and support for clients that is within their own set of skills and experience.

The elements of work that a solicitor may provide could include:

  • Due diligence
  • Financial analysis
  • Project management
  • Strategy development
  • Legal research
  • Template selection and bespoke drafting
  • Negotiation
  • Document management
  • Legal advice
  • Risk assessment

Helping directors develop a turnaround plan

To claim protection under the safe harbour there is no requirement that a director actually executes a turnaround plan. The obligation upon a director is to “develop” a course, or courses, of action that is “reasonably likely to lead to a better outcome for the company”. The first consideration is that the onus is quite low, given the alternative could involve the extinguishment of goodwill in a business and a fire sale of assets through liquidation or voluntary administration. The second consideration is that it may be that ultimately the best outcome is an orderly liquidation or sale of assets and that whilst this is being undertaken a director can legitimately claim the safe harbour.

The new safe harbour could foreseeably find a place for prudent solicitors to help clients to evaluate and create sensible turnaround plans or at least prepare for orderly liquidations.

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