Australia: Insolvency safe harbour for directors

Last Updated: 25 October 2010
Article by Karen O'Flynn

David Bushy, Boardroom Radio

Karen O'Flynn, Partner, Clayton Utz

Listen to the Radio Interview here.


Welcome to Boardroom Radio.

Australia's insolvency industry has been highly active for the best part of two years now and with the fallout of the GFC providing ongoing activity for practitioners, the industry now faces numerous calls for reform stemming from the long-running Senate inquiry released last month. Together with recent guidance and reporting from ASIC, there's no shortage of issues for practitioners and company directors to think about. Joining us to discuss is Karen O'Flynn, who heads up the restructuring and insolvency team for Clayton Utz. She joins us from Sydney. Welcome Karen.


Hello David, thank you.


Karen can we start with the current insolvent trading regime. What is the risk that directors are faced with at the moment? What keeps them up at night?


The Corporations Act imposes personal liability on directors for debts incurred by their company whilst it's insolvent and that personal liability can come home to roost in two ways. First of all, the liquidator of an insolvent company can sue a director for the debts incurred by the company whilst it was insolvent and, secondly, because the duty to prevent insolvent trading is both a civil penalty provision and a criminal penalty provision, it can be enforced by our corporate regulator, ASIC.

If a director breaches the civil penalty provision, then the penalties which the court can impose include disqualifying him from managing a company for a specified period of time, or paying a penalty of up to $200,000, or paying compensation to the company. If the additional element of dishonesty is made out, then under the criminal penalty provisions, the director could be fined up to $200,000 and imprisoned for up to five years.


Karen, are we actually seeing that? Have we seen that sort of thing happen in recent times?


It's very interesting that you ask that David because there's quite a disconnect between the commonly held fear that directors genuinely hold in relation to their personal liability for insolvent trading, and I'll talk about that a little more in a moment, and the statistics that are revealed if anybody looks at the cases that have been pursued in relation to insolvent trading.

There aren't many empirical studies of insolvent trading cases. The only one of which I'm aware was conducted by one of my partners, Paul James, and Professor Ian Ramsay and others, and published in 2004. That looked at 103 cases that had gone to judgment and it's fair to say that in most of those, about 75%, directors were found liable for insolvent trading but the penalties or compensation orders that they were required to make were relatively low. There's one outlier of about $95 million, but if you take that one away the average pecuniary penalty, whether that's a penalty to the Government or a compensation order to the company, was about $100,000.


So it seems they're not feeling the wrath of the law, plus there are defences that are presently available to directors. What kind of defences are we talking about here?


There are at least four defences that directors can rely on.

The first is that the director had reasonable grounds to expect, and did expect, that the company was solvent, not insolvent.

Secondly, the director had reasonable grounds to believe, and did believe, that a competent and reliable person was responsible for providing him with adequate information about the solvency of the company, and that other person was fulfilling that responsibility.

The third possibility is that the director had a good reason, such as illness, for not taking part in the management of the company, and the last that I'm going to mention is that the director took all reasonable steps to prevent the company from incurring the debts.


And I understand there are numerous calls for reform in this space. Can you run us through those?


Well interestingly in January this year, the Commonwealth Government published a paper which is called "The Safe Harbour Discussion Paper" and the paper proposes three options for reform: the first is not to do anything, stick with the current law. The second is to introduce a modified judgment rule defence which would be available if a director could prove four things to the satisfaction of the court in addition to satisfying the elements of the existing business judgment rule defence.

The four new things are:

  • first, that the financial accounts and records of the company presented a true and fair picture of its financial circumstances;
  • next, the director was informed by appropriate restructuring advice based on those accounts and records;
  • thirdly, it was the director's business judgment that the interests of not just the company's creditors but also its members, were best served by pursuing the restructure; and
  • lastly, the director got on and diligently pursued the restructuring.

So that's the second of the three options. The last is to introduce what would, in effect, be a new form of insolvency administration and under that the company would publicly announce that it was insolvent and intended to pursue an informal debt workout. A moratorium would then apply, during which honest, insolvent trading on the part of the directors would be permitted and then creditors could bring the moratorium to an end by either passing a resolution or obtaining a court order.


And why aren't these reforms now on the table? Is this really as a result of the GFC and the fallout that we saw in the prosecutions which also followed suit? What are the key arguments for these reforms?


There is quite a lot of evidence. In particular Treasury conducted a survey of ASX 200 company directors in 2008 that the fear held by directors of insolvent trading liability is a real brake or inhibition on board decision-making processes.

Also, there's evidence that although the current law has, as one of its policy foundations, the thesis that our system encourages directors of financially distressed companies to appoint a voluntary administrator sooner rather than later, the real position seems to be that most directors only embrace external administration when the ship has already run aground.


When it's too late.


It's too late, exactly so. And that means that the prospect of the company being rehabilitated whilst it's in voluntary administration is very much reduced.

So one of the primary drivers for these calls for reform is that is firstly the desire to provide a safe harbour for directors whilst they're honestly and diligently exploring an informal workout, which hopefully will achieve its objective, and linked to that the thinking is that that sort of protection will encourage directors to do what they're not doing now, that is, seek professional restructuring advice much sooner.


And in terms of your position, you obviously see a lot of these come across your desk. What reform options do you prefer Karen?


Well, I certainly am of the view that maintenance of the status quo isn't supportable.

The other end of the spectrum is the Government's suggestion that directors should simply be able to invoke this unilateral debt moratorium. That to me seems hopelessly impractical and in some extreme cases might even encourage phoenix company activities.

My preferred option is the second of the three options, the internal management/external advice model. Under that proposal the directors can pursue a debt restructuring plan without being liable for fresh debts, provided they've taken that important, professional restructuring advice.

Of course I'm very ready to accept that the devil will be in the detail and I wouldn't want us to end up with a statutory defence which simply sets the bar too high to be of any practical use.


And just finally, what are the next steps? Are we likely to see which option is ultimately pursued any time soon?


That's impossible for me to predict. The new Federal Government's got a lot on its legislative agenda and I suspect that this is not in the top 10. More than that I can't say.


Is this something that people are currently putting submissions into Government on?


Yes, yes indeed. The time for submission has closed and there were a very large number of submissions from organisations such as the Australian Institute of Company Directors, Insolvency Practitioners' Association of Australia and so on.


Well, as you said, we'll certainly keep a close eye on it to see if and when the Government does act. But thank you again for your insights today Karen.


It was a pleasure, thank you David.


That was Karen O'Flynn who heads up the restructuring and insolvency team for Clayton Utz.

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