Australia: Directors take note: Law reform to promote corporate restructuring

Last Updated: 5 May 2017
Article by Marguerite Xavier and Wylie Thorpe

Most Read Contributor in Australia, August 2018

The Commonwealth Government has released draft legislation1 that proposes significant amendments to the Corporations Act 2001 (Cth) (Corporations Act) by introducing:

  1. a 'safe harbour' regime for company directors from personal liability for insolvent trading if the company is undertaking a restructure; and
  2. a stay on the enforcement of 'ipso facto' clauses (contractual clauses which allow contracts to be terminated or modified due to an insolvency event) during an administration of a company or a scheme of arrangement.

The draft legislation is intended to promote a culture of entrepreneurship and innovation and reduce the stigma associated with business failure by:

  1. encouraging directors to engage early should a company fall into financial hardship and take reasonable risks to facilitate the company's restructure rather than placing the company prematurely into voluntary administration or liquidation; and
  2. preventing contractual parties from exercising their rights under 'ipso facto' clauses in order to terminate or modify a contract on the basis of an insolvency event without having regard to the ability of the company to perform the contract. This can deprive the company of the opportunity to continue to trade through a restructure 2.

Safe harbour defence

Section 588G of the Corporations Act currently imposes liability on company directors who cause the company to trade whilst it is insolvent.

The amendments seek to introduce section 588GA into the Corporations Act which provides that a director will have a defence to personal liability for debts of the company if, at a particular time after the director suspects the company may become or be insolvent, the director starts taking a course of action that is reasonably likely to lead to a better outcome for the company and the company's creditors.

The defence will apply to debts incurred when the director starts taking a course of action and ends when the course of action ends or stops being reasonably likely to lead to a better outcome for the company and its creditors or the company goes into administration.

A 'better outcome' for the company and its creditors will be assessed on an objective basis and is determined against the outcome of the company entering administration, receivership or liquidation. The proposed amendments include a non-exhaustive list of factors which will be taken into account when determining whether a director's actions are reasonably likely to lead to a better outcome for the company and its creditors as a whole. These amendments include:

  1. 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;
  2. taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company;
  3. obtaining appropriate advice from an appropriately qualified entity who was given sufficient information to give appropriate advice;
  4. properly informing himself or herself of the company's financial position; and
  5. developing or implementing a plan for restructuring the company to improve its financial position.

The safe harbour defence will not be available to directors where the company fails to provide (to a reasonable standard) employee entitlements (such as superannuation), maintain required books and records or report financial information required by taxation laws.

If introduced in its current form, the safe harbour defence will take effect on the day after the amending Act receives Royal Assent.

Stay on 'Ipso facto' clauses

An 'ipso facto' clause is a standard contractual clause that allows one party to terminate or modify a contract upon the occurrence of an insolvency event.

The amendments seek to introduce sections 415D-E and 451E-F into the Corporations Act which will provide for an automatic stay on the exercise of 'ipso facto' rights in the event of a company entering voluntary administration or a scheme of arrangement. The stay does not apply to a company in liquidation or where receivers and managers have been appointed. The automatic stay will operate:

  1. in respect of a scheme of arrangement, from the time the company makes an application to enter a compromise or arrangement and ends when:
    1. the application is withdrawn or the court dismisses the application;
    2. at the end of an approved compromise or arrangement; or
    3. if the compromise or arrangement ends because of a resolution or order for the company to be wound up, when the company is wound up
  1. in respect of voluntary administration when the administration begins and ends when:
    1. the administration ends;
    2. a period extended by order of the court; or
    3. if the administration ends because of a resolution or order for the company to be wound up, when the company is wound up
  1. otherwise until the court exercises its powers to lift the stay if it is satisfied that it is in the interests of justice to do so.

The stay on the enforcement of 'ipso facto' rights does not apply in relation to contracts:

  1. to be prescribed by regulation, which are currently proposed by the Commonwealth Government to include, for example, rights of set-off, securities underwriting agreements, flawed asset arrangements, covered bond transactions and debt factoring agreements;
  2. of a kind prescribed in ministerial declaration, which will allow any unintended consequences which may result from the automatic stay to be remedied; and
  3. that manage financial risk associated with a financial product that is commercially necessary for that type of financial product. For example, swaps, where the party is entitled to close out their position in order to manage counterparty risk.

The amendments also seek to introduce sections 415F and 451G into the Corporations Act which will give the court power to order that other contractual rights will only be enforceable with leave of the court or on conditions imposed by the court, if those rights are merely being exercised because the company is subject to a scheme of arrangement or under administration.

If introduced, the stay on the enforcement of the 'ipso facto' clauses will take effect from the later of 1 January 2018 or the day the Act receives Royal Assent (if that date is later).

What this means for you

In respect of the proposed safe harbour amendments:

  1. Company directors will need to ensure that in the course of restructuring if it becomes apparent that the steps being taken will not lead to a 'better outcome', the director should either adjust the course of action or place the company into administration or liquidation.
  2. As the test is objective, there is a risk that directors may not meet the requirements to take the benefit of the 'safe harbour' provisions despite their subjective intention. The Explanatory Memorandum makes it clear that where a company cannot objectively be considered viable in the long term, the course of action will not be reasonable and therefore directors will not be able to take the benefit of the defence.
  3. The test is likely to result in a significant body of case law. Directors should familiarise themselves with the list of non-exhaustive factors which will be taken into account by the court when determining whether a director has adopted a course of action that is reasonably likely to lead to a better outcome.
  4. Directors should seek legal or other advice in respect of the proposed restructure to demonstrate that appropriate advice was obtained. The Explanatory Memorandum makes it clear that the advice sought will depend on the nature and size of the company. For example, a small company may only need to take advice from an accountant or lawyer whereas a listed entity may retain turnaround specialists, insolvency specialists, lawyers and accounting firms to advise on a reasonable course of action.
  5. The amendments may lead to greater risk taking in corporate restructuring and investors and other financial providers may consider it prudent to incorporate contractual clauses which will allow greater oversight over, and monitoring of, company activities where there is an insolvency event.

In respect of the proposed stay on the enforcement of 'ipso facto' rights:

  1. Parties to commercial contracts should assess how they may be impacted by the proposed stay on 'ipso facto' clauses and consider measures that can be taken to minimise the effect of such clauses on the occurrence of an insolvency event.
  2. Notwithstanding the operation of the stay, a contractual party will retain the right to terminate a contract for any other breach, such as non-payment or non-performance.
  3. A number of contracts are proposed to be excluded from the stay on 'ipso facto' clauses, however, that does not currently include credit contracts which may result in lenders not being able to enforce security under those contracts. However, the stay would not require any creditor to provide a new advance of money or credit or to provide additional security for further credit to a debtor company 3.
  4. Creditors should remain vigilant and monitor their contractual relationships with debtor companies. Creditors should engage early in open dialogue with company directors because that interaction may assist a turnaround and reignite further business in the future if a restructure is successful.
  5. The Commonwealth Government is currently considering the public submissions received in response to the draft legislation which may inform the final version of the legislation.

Holding Redlich will monitor the passage of the legislation through Parliament and provide further updates.

Footnotes

1 Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 (Cth) (exposure draft).

2 Commonwealth Government, Treasury, "National Innovation and Science Agenda - Improving Corporate Insolvency Law", 28 March 2017: HTTP://www.treasury.gov.au/ConsultationsandReviews/Consultations/2017/NISA-Improving-corporate-insolvency-law

3 Explanatory Memorandum, Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 (Cth), paragraph 2.10-2.11.

This publication does not deal with every important topic or change in law and is not intended to be relied upon as a substitute for legal or other advice that may be relevant to the reader's specific circumstances. If you have found this publication of interest and would like to know more or wish to obtain legal advice relevant to your circumstances please contact one of the named individuals listed.

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