Australia: Safe harbours and unenforceable ipso facto clauses on the way for Australian insolvency law

Last Updated: 13 December 2015
Article by Karen O'Flynn

The Australian Government has accepted certain recommendations of the Productivity Commission's long-awaited Report on Business Set-up, Transfer and Closure, in an attempt to change the focus of Australia's insolvency laws from "penalising and stigmatising business failure", according to the Minister for Small Business and Assistant Treasurer, the Hon Kelly O'Dwyer MP.

It has expressed a willingness to legislate to introduce at least two main changes:

  • introduce a safe harbour for directors from personal liability for insolvent trading if they appoint a restructuring adviser to develop a turnaround plan for the company; and
  • make "ipso facto" clauses, which have the purpose of allowing contracts to be terminated solely due to an insolvency event, unenforceable if a company is undertaking a restructure.

Although the proposed changes are steps in the right direction for the turnaround and restructure of distressed companies, any changes will need to be made carefully to avoid unintended consequences, particularly regarding the interests of creditors.

A cultural shift: removing the fear of failure

The Report noted two cultural views that affect restructuring in Australia:

  • a perception that Australia's insolvency regime provides insufficient focus on, or incentives to, restructure, particularly compared to the US regime (ie. Chapter 11); and
  • the stigma attached to corporate failure in Australia.

The contrast between the US and Australian regimes is an interesting one and one that we consider reflects our subtle cultural differences. Generally speaking, it is also replicated in some of the fundamental aspects of our respective insolvency regimes.

For example, under Chapter 11 directors of an insolvent company usually drive the insolvency process. Conversely, under Australian law, an external party (ie. an insolvency practitioner) takes over the reins from the directors whose powers are suspended on appointment of an insolvency practitioner (eg. under section 437C of the Corporations Act 2001 (Cth) once a company is under administration).

Australians, for the most part, are more sceptical of our failed companies and directors whereas, in the US, it is often said that a failed director wears such experience as a badge of honour.

The Government's response to the Productivity Commission's Report (mirrored in its other announcement on Monday on innovation policy) makes a clear push to encourage risk-taking and innovation and taking steps to ensure our insolvency regime does not detract from these pursuits. This might be a challenge in practice, given the countervailing need in insolvency law to protect creditors, which we look at below.

The key recommended reforms to Australian insolvency law

The Report took a view that the current culture, incentives and legal framework of the Australian insolvency regime inhibit its effectiveness as a genuine restructuring mechanism. Therefore, while wholesale change to the Australian insolvency system (such as the introduction of a "debtor in possession" regime in line with Chapter 11) is not justified, the Report conceded that some specific reforms were warranted.

Corporations Act

The Corporations Act should be amended:

  • to provide that within one month of his or her appointment, an administrator must certify that they have reasonable grounds to believe that the company (or the entity that may emerge following a restructure) is capable of being a viable business;
  • to allow for a "safe harbour" defence to insolvent trading;
  • to make provision for "pre-positioned" sales (ie. "pre packs");
  • to deem "ipso facto" clauses (ie. clauses that have the purpose of allowing termination of contracts solely due to an insolvency event) unenforceable if the company is in voluntary administration or the process of forming a scheme of arrangement;
  • to create a moratorium on creditor enforcement action during the formation of insolvent schemes of arrangement (ie. to align the approach currently used in voluntary administration); and
  • to provide for a simplified "small liquidation" process (ie. those companies with liabilities to unrelated parties of less than $250,000).

The Australian Government should instigate an independent review of the relevant parts of the Corporations Act and the practices of receivers in the market.

Bankruptcy Act

The Bankruptcy Act 1966 (Cth) should be amended so that, where no offence has occurred, a bankrupt is automatically discharged after one year. Specifically, this should apply to restrictions relating to overseas travel, holding an office under the Corporations Act, employment within certain professions and access to personal finance.

Protecting creditors vs promoting risk-taking

It is clear that the Government is focusing on fostering entrepreneurship and innovation. Built into these concepts is the suggestion that greater risk-taking should be promoted.

However, how do these pursuits marry up with our insolvency regime? A review of the Report and the subsequent statements from Government suggest that there is an inconsistency between what the Government is now seeking to achieve and what the insolvency regime currently promotes.

Is this a surprise?

While entrepreneurship, innovation and risk-taking are all necessary and noble pursuits, any reforms to encourage this type of behaviour should be balanced with the protection of creditors (which must be kept front of mind) as it is creditors that ultimately need to be protected in the event of insolvency.

The protection of creditors is fundamental to our insolvency regime. It will be interesting therefore to see how the ultimate legislation will balance companies' and directors' ability to take risks against the protection of creditors.

Promoting restructurings via safe harbours and ipso facto clauses

There is also, in our view, a difference between risk-taking and the promotion of successful restructurings. Successful restructurings do not necessarily require risks. In some instances, flexibility is the key.

Although the Federal Government has an express intention to introduce a safe harbour for directors and deeming ipso facto clauses void upon insolvency, it is unclear how these two initiatives alone will impact restructurings given existing protections under the Corporations Act.

Under section 443A(1) of the Corporation Act, an administrator is personally liable for certain debts he or she incurs (a similar provision, section 419 of the Corporations Act, applies with respect to a "controller" of a corporation). There is no doubt that the intention of this provision is to encourage contracting parties to continue to deal with insolvent companies (which is a very similar outcome to the effect of voiding of ipso facto clauses).

Additionally, depending on the final form of the legislation and following its enactment, parties to a contract could draft around the legislative prohibition deeming ipso facto clauses void on insolvency by providing additional termination rights over and above just the right to terminate on insolvency of the counterparty that may also be easily triggered on the company's insolvency (for example a material adverse change in the company's circumstances).

Whether a safe harbour will result in greater restructuring opportunities remains to be seen. We query if an independently-appointed external advisor appointed pre-insolvency could achieve what an administrator could not achieve post-insolvency.

Additionally, it is wrong to suggest that the current regime does not purport to promote restructuring. Section 435A(a) of the Corporations Act is clear that the objective of Part 5.3A (ie. the voluntary administration regime) is to provide for the business, property and affairs of an insolvent company to be administered in a way that "maximises the chances of the company, or as much as possible of its business, continuing in existence..." It is the execution of this objective that is the key to its success.

The above discussion does not mean that it is our position that the above changes should not be introduced. On the contrary, we consider that these initiatives should be wholeheartedly encouraged. What it does highlight is that the scope for real change will be dependent on the drafting of the legislation and the execution of the objective of the legislation.

Pre-packs as a viable alternative to traditional restructuring

Of particular interest, over and above the often mooted changes regarding safe harbours and ipso facto clauses, in our view, is the recognition of pre-packs as a viable alternative to the traditional restructuring options of a deed of company arrangement or scheme of arrangement.

As it currently stands, pre-packs are generally advised against because the controller or administrator may be found to have been derelict in his or her duties under the Corporations Act (or general law) if the sale is completed. This is most obvious in the context of a controller's obligations under section 420A of the Corporations Act. The commonly held (and some would argue, conservative) view is that a controller (eg. a receiver and manager) must undertake their own sale process to satisfy these obligations ? which means taking the assets to market and undertaking a responsible sale campaign. This does not necessarily lend itself to a pre-pack.

Accordingly, any change that purports to encourage pre-packs must, in the ordinary course, provide some protection to, and flexibility for, the insolvency practitioner that has undertaken the sale (either by way of amendments to section 420A or otherwise).

In the context of a pre-packaged administration, the obligations of an administrator could be better elucidated so as to give the administrator confidence that he or she could effect a pre-pack and still comply with his or her obligations to creditors. Further, flexibility would need to be built into the requirement and timing of creditors' meetings and reports and there would need to be less rigid timetables in an administration generally. Again, flexibility is the key.

A discussion paper is on its way

Three months ago we predicted in From Red to Black that this year would see a continued push for the introduction of safe harbour defences for directors undertaking workouts and continued discussion about Chapter 11 and if it (or parts thereof) should be introduced into Australian law.

The discussions regarding ipso facto clauses and safe harbour provisions (amongst other initiatives) are encouraging for the state of the restructuring landscape in Australia for 2016 and beyond. We look favourably upon any proposed legislation that may provide an improved platform for effective restructures and better returns for creditors in the long run.

However, the real impact of these proposed changes remains to be seen, as much will depend upon their final form.

We understand that a proposal paper will be released in 2016, with legislation expected to be introduced in mid-2017.

We look forward to further information and discussion around precisely how the Corporations Act will be amended, so that it can foster real restructures and turnarounds of distressed companies.

We also encourage the Government to ensure sufficient flexibility is built into the current regime and into the proposed amendments, so that tangible change can be implemented.

Finally, while a shift in focus regarding risk taking and the stigma of insolvency makes sense, this needs to be balanced with the requirement to ensure creditors are adequately protected.

We will watch this space with interest.

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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