Background
On 7 December 2015, the Australian Government released its "National Innovation and Science Agenda" ("Agenda"). In the Agenda, the Government outlined its intention to make three significant reforms to Australia's insolvency laws, adopting the recommendations of the Productivity Commission ("Commission") in its report, "Business Set-Up, Transfer and Closure" ("Report"), released on the same day as the Agenda:
- Reducing the default bankruptcy period for individuals from three years to one year;
- Introducing a "safe harbour" providing directors with immunity from personal liability for insolvent trading under section 588G of the Corporations Act 2001 (Cth) ("Act") during the implementation of a restructuring plan; and
- Preventing the enforcement of "ipso facto" contractual clauses during a restructuring attempt.
Insolvency reforms of the kind proposed in the Agenda have long
been welcomed in the industry. Indeed, there has been a widespread
view that directors have increasingly appointed voluntary
administrators to companies at the first sign of financial trouble
to take advantage of the defence to insolvent trading in sections
588H(5) and 588H(6) of the Act. Voluntary administration has in
turn triggered the destruction of companies' enterprise value
as core creditors and suppliers have terminated their contracts in
reliance on ipso facto clauses that apply when companies experience
an "insolvency event". All too often, those companies
have eventually ended up being liquidated, and employees and other
unsecured creditors have faced significant losses.
In progressing the reforms, the Government released a proposals
paper, "Improving Bankruptcy and Insolvency Laws"
("Proposals Paper"), on 29 April 2016 for public
consultation.
Reduced Bankruptcy Period
According to the Proposals Paper, reducing the default
bankruptcy period (along with relevant restrictions that apply
during bankruptcy such as credit and travel restrictions) to one
year is designed to "encourage entrepreneurial endeavour and
reduce associated stigma".
The reduced default bankruptcy period, which brings Australia into
line with the default period in the United Kingdom, is a welcome
reform which recognises that bankruptcy is not always the
consequence of any "misconduct" by an individual and that
genuine business failure is an ordinary part of a well-functioning
economy. The pecuniary association given to bankruptcy in Australia
has regrettably entrenched a "fear of failure" that has
inhibited the development of an entrepreneurial culture of the kind
seen in the United States.
However, in accordance with the Commission's recommendation in
the Report, it is proposed that the default bankruptcy period may
be extended for an individual bankrupt (as is currently the case)
if the bankrupt has engaged in misconduct, for example by failing
to pay assessed income contributions. The retention of the
extension period is designed to prevent abuse of the bankruptcy
process by individuals seeking to avoid liability for their
debts.
The Proposals Paper also adopts the Commission's recommendation
for a bankrupt's obligation to pay income contributions to be
separated from the default bankruptcy period, so that income
contributions will be payable for three years (if the bankruptcy
period is not extended due to misconduct) even with a reduced
default bankruptcy period.
Safe Harbour from Insolvent Trading Liability
The Proposals Paper outlines two options for implementing a safe
harbour.
"Model A" closely follows the Commission's
recommendation in the Report that, to limit the prospect of abuse
to the detriment of a company's creditors, directors should be
able to invoke a safe harbour defence from insolvent trading only
if they are diligently implementing a restructuring plan created by
an insolvency and turnaround adviser appointed by the
company.
Under Model A, directors will not face liability for insolvent
trading if they have a reasonable expectation, based on advice
provided by an experienced, qualified and informed restructuring
adviser, that the company can be returned to solvency within a
reasonable period of time and they are taking reasonable steps to
ensure it does so (for example, by putting in place the steps
recommended by the adviser in a restructuring plan).
So that the restructuring adviser can make an informed assessment
of the company's future viability, Model A requires directors
to provide the adviser with up-to-date books and records reflecting
the company's transactions and financial position.
To enable it to refine Model A in greater detail, the Government is
seeking public views on matters including:
- The qualifications and experience expected of a restructuring adviser, including the level of professional accreditation required;
- The factors that should be taken into account by a restructuring adviser in determining whether a company is viable;
- The nature of a restructuring adviser's role and the protections from personal liability that should be available to an adviser; and
- The circumstances where the safe harbour defence should not be available—for example, in cases where a director has previously breached his or her duties to the detriment of creditors or where a company has not complied with its obligations to pay taxes or employee entitlements.
In contrast to Model A, "Model B" adopts a far more
flexible approach to director liability. It does not require
directors to appoint a restructuring adviser to avoid liability for
insolvent trading, and it implements the safe harbour as a
"carve out" from the primary definition of insolvent
trading in section 588G of the Act rather than as a defence to
insolvent trading.
Specifically, under Model B, section 588G of the Act will be taken
not to apply where:
- A debt is incurred as part of reasonable steps taken by directors to maintain or return a company to solvency within a reasonable period of time;
- Directors hold the honest and reasonable belief that the incursion of the debt is in the best interests of the company and its creditors as a whole; and
- The incursion of the debt does not materially increase the risk of serious loss to creditors.
Model B has the benefit of encouraging greater collaboration between directors and the full range of a company's creditors in circumstances of financial difficulty, with the Government noting in the Proposals Paper that early engagement with creditors and other corporate stakeholders would form part of the Court's consideration of whether directors have taken "reasonable steps" to maintain or return a company to solvency. While it is indicated in the Proposals Paper that the appointment of a restructuring adviser will also be a relevant factor for the Court to consider in that regard, Model B avoids the development of a formulaic "one size fits all" approach that requires the appointment of a restructuring adviser in all cases for the safe harbour to be validly invoked.
Ipso Facto Clauses
In their most basic form, "ipso facto" contractual
clauses enable a party, such as a supplier or a financier, to
terminate a contract with a company if the company experiences an
"insolvency event", which is usually defined in the
relevant contract to include the appointment of a liquidator,
receiver or voluntary administrator; a company's negotiation of
a scheme of arrangement; and/or a company's technical
insolvency under section 95A of the Act.
To maximise the potential for a company or its business to be
revived, the Commission recommended in the Report that ipso facto
clauses should be unenforceable during voluntary administration or
the negotiation of a scheme of arrangement.
The Proposals Paper adopts this recommendation, while also
including the appointment of a receiver and a company's entry
into a deed of company arrangement within the circumstances where
an ipso facto clause allowing termination of a contract will be
void. However, the Government intends to exclude "prescribed
financial contracts" (which may potentially cover swaps,
derivatives and closeout netting contracts) from the restriction on
the enforcement of ipso facto clauses. It is also proposed to allow
individual suppliers and creditors to apply to the Court for
permission to terminate a contract if they have suffered particular
hardship.
Notably, the Proposals Paper does not contemplate that the ipso
facto enforcement restriction will apply where a company is
pursuing an informal restructuring attempt outside the
control of an external administrator—that is, in the
circumstances contemplated in Model A and Model B of the proposed
safe harbour provisions. That is a significant omission because,
while a safe harbour is likely to increase the willingness of
directors to pursue a workout attempt in the interests of creditors
instead of prematurely appointing a voluntary administrator, it
cannot be assumed that all creditors will wish to cooperate in an
informal restructuring attempt. If a key creditor or supplier seeks
to withdraw its support for a company by terminating its contract
with the company, the prospect of the restructuring attempt being
successful will be compromised.
In the Proposals Paper, the Government seeks input on the
appropriateness of the ipso facto reforms, including whether
contractual clauses allowing a party to enforce rights other
than termination upon the occurrence of an insolvency event,
such as payment acceleration or the requirement for additional
security, should also be void.
In that regard, more extensive enforcement restrictions are
currently included in the United States reorganisation process in
Chapter 11 of the Bankruptcy Code ("Code"). For
example, section 363(l) of the Code prevents a counterparty from
forfeiting, modifying or terminating a company's interest in a
contract for the use, sale or lease of property based on the
company's insolvency or financial condition (including the
commencement of a Chapter 11 case), while sections 365(e) and
365(f) of the Code prevent counterparties from restricting the
assignment of, terminating or modifying executory contracts or
unexpired leases in those circumstances. Even more broadly, the
Code provides for a suspension of the enforcement rights of secured
creditors during the pendency of a Chapter 11 case as long as such
creditors are provided with "adequate protection" of
their interests. It is also possible for a Chapter 11
reorganisation plan to override the enforcement rights of secured
creditors (the so-called "cramdown" mechanism) as long
as, among other things, the treatment of such creditors' claims
under the plan is "fair and equitable".
While broader enforcement restrictions, outside the exercise of
termination rights, would increase the incidence of corporate and
business rescue in Australia, the Government would need to ensure
that any such restrictions still leave creditors with sufficient
avenues to protect their interests in the event of
insolvency—for example, by employing "adequate
protection" and "fair and equitable" concepts
similar to those adopted in the United States. Failure to do so may
significantly increase the cost and/or reduce the supply of credit
for companies, to the detriment of employees, other corporate
stakeholders and the economy more broadly.
A Broader Move to a Chapter 11 Process in Australia?
In the Report, the Commission recommended against the wholesale
adoption of a Chapter 11 restructuring framework in Australia,
indicating that the excessive costs and delays, as well as cultural
differences between Australia and the United States, would make
that option unpalatable to the Australian public. Nevertheless, the
Commission recognised the merit in further investigating the use of
"certain components" of the Chapter 11 process to advance
corporate and business rescue in Australia. The Commission's
recommendations in that regard are consistent with previous
recommendations made by the Government's Financial System
Inquiry and the Senate Economics References Committee's ASIC
Inquiry in 2014.
While the Proposals Paper does not specifically refer to Chapter 11
and, apart from the possible extension of the proposed ipso facto
moratorium, does not indicate any movement toward features
coextensive with the Chapter 11 process, it is hoped that the
Government will explore the Commission's recommendations in
further detail in future years.
Next Steps in the Reform Process
While the intended insolvency law reforms are long overdue, it
is suggested that Model B of the proposed safe harbour provisions
may be more preferable than Model A because of Model B's
flexibility and the likelihood that it will encourage greater
involvement of creditors in a collective informal workout attempt.
The appointment of a restructuring adviser as a precondition to the
operation of a safe harbour for directors may not be appropriate
every time a restructuring attempt is contemplated and risks a
nonconsultative process that excludes or limits creditor
involvement.
Further, to enhance the likelihood of a collective creditor process
and an ultimately successful restructuring attempt, the Government
should consider extending the ipso facto enforcement restriction to
circumstances where directors are pursuing a workout in the manner
contemplated by the proposed safe harbour provisions. Broader
enforcement restrictions similar to those which apply under the
Chapter 11 process in the United States also warrant further
investigation.
Public submissions on the Proposals Paper close on 27 May 2016.
With the Federal election due on 2 July 2016, it is hoped that the
new Government continues diligently to progress the insolvency
reforms by preparing draft legislation and actively engaging with
stakeholders in what would appear to be the most significant
adjustment to Australia's insolvency landscape in the last
decade.
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