Australia: Any port in a storm? Analysing safe harbour and ipso facto insolvency reforms

Much has been written and discussed about Australia's draconian insolvent trading laws and the Federal Government has taken note. It has released draft legislation seeking to amend the Corporations Act in a way that supports the restructuring of financially distressed companies. But do these amendments go far enough in providing companies with the time and space they require when they're seeking to implement a financial restructuring plan?

BACKGROUND

The ( Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017) (the Bill) introduces:

  • a 'safe harbour' for directors who are seeking to develop or implement a restructuring of a company. This will see the directors shielded from personal liability for insolvent trading under section 588G of the 2001 (Cth) (Corporations Act); and
  • a stay on the enforcement of 'ipso facto' clauses in a contract that are triggered when a company enters formal insolvency proceedings.

The ipso facto reforms will take effect from 1 January 2018, while the safe harbour reforms do not yet have an implementation date but may take effect earlier than 1 January 2018.

SAFE HARBOUR FROM PERSONAL LIABILITY

It's widely accepted that reform in this area is required to increase the chances of turning around viable (or potentially viable) companies in the zone of insolvency (or the 'twilight zone') without the fear of personal liability for directors.

Under the current legislative framework, it's understandable that when faced with potential personal liability, directors may seek protection through the appointment of an insolvency practitioner rather than using informal restructuring techniques to turn the company's fortunes around. It is generally accepted that prematurely placing a company into a formal insolvency process can destroy value for key stakeholders (including employees and creditors).

At present, under section 588G of the Corporations Act, a director of a company may be personally liable for debts incurred by the company if, at the time the debt is incurred, there are reasonable grounds to suspect that the company is insolvent or would become insolvent. This duty currently focusses on the timing of when debts are incurred by a company rather than the conduct of the directors in incurring that debt. This focus on timing adversely impacts the decisions of directors and does not give them sufficient means to implement a restructuring.

Several foreign jurisdictions, most notably England, have for some time now moved away from formal insolvencies toward informal restructurings, turnarounds and business rescues. Often this is achieved in a legislative environment which allows directors sufficient breathing space to concentrate on bringing together key stakeholders for the purpose of deleveraging the company's balance sheet and fixing its business operations. This has led to countless numbers of businesses right-sizing their balance sheets at the same time as implementing much needed operational turnarounds.

By removing the liability risk and promoting a culture of entrepreneurship, directors should, as the Explanatory Memorandum to the Bill suggests, be free to innovate and take reasonable risks to restructure viable companies. But do the proposed safe harbour provisions provide sufficient comfort and clarity to directors, as is the case in England? Are they encouraged to trade through the twilight zone in the hope of safe harbour protection?

To benefit from the safe harbour protection in the proposed new section 588GA, which will act as a carve out to section 588G(2) liability, a director will need to overcome four hurdles to ensure the director will not be personally liable for newly incurred debts.

Better Outcome

The first hurdle is for directors to "start taking a course of action that is reasonably likely to lead to a better outcome for the company and the company's creditors". A 'better outcome' is one where the company and its creditors as a whole are better off compared to the company going into administration, receivership or being wound up.

Importantly, the safe harbour can still apply to a director where the ultimate result of taking on further debt is formal insolvency. Provided that the director was pursuing a reasonable course of action which was likely to lead to a better outcome then the director will still have the benefit of safe harbour.

There is a list of non-exhaustive factors (as a guide only) to consider when determining whether a course of action is reasonably likely to lead to a better outcome. These include whether the director is: (i) obtaining appropriate advice; (ii) ensuring the company is keeping appropriate financial records; and (iii) developing or implementing a plan for the restructuring of the company to improve its financial position. The Explanatory Memorandum makes it clear that it is not necessary for all of the list of factors to be present to enable the director to rely on the safe harbour and, in fact, it may be possible for the defence to apply even where none of those factors are present.

The Explanatory Memorandum also indicates that the term "the company's creditors as a whole" is intended to cover both existing and new creditors. This may create problems for the directors in terms of assessing the likely outcome of the restructuring for each of these two separate constituencies, especially where each of their interests are not aligned in the particular course of action chosen.

The "better outcome" test is an objective one which will only be tested after the fact and differs from the original proposal which contained a subjective element (see Proposals Paper). Further, directors are not required to "return the company to solvency within a reasonable period of time", which was also a feature of the original proposals. Arguably, this first hurdle may be the easiest to overcome as the section has a wide application to ensure that directors of organisations of any size or nature can potentially benefit from the provisions. They are not required necessarily to incur significant cost in complying with a prescribed list of factors to be afforded protection.

However, the evidential burden rests with the director to demonstrate that the course of action chosen was reasonably likely to lead to a better outcome for the company and its creditors as a whole. The onus will then shift to a liquidator (or a third party who had acquired the cause of action from the liquidator) alleging a breach of section 588G(2), to prove that the safe harbour doesn't apply because the course of action was not a reasonable one.

Importantly, directors will not be able to use books or information as evidence to support a safe harbour defence where these materials have previously been withheld from an administrator or liquidator following an appropriate request for such materials. This is designed to prevent directors from withholding such information to limit investigations into the activities of the company and its directors.

Debts Incurred

The next hurdle will be for the director to establish that the debts incurred were debts incurred in connection with that "better outcome" course of action. If the debt is incurred when the particular course of action is no longer reasonably likely to lead to a better outcome, or when the company has been placed into administration or is being wound up, the exclusion will no longer apply.

It is unclear at this stage whether in overcoming this hurdle, normal trading debts would be considered debts to be incurred in connection with that course of action. Although we would like to assume normal trading debts are to be covered, it is far from clear in the Bill. In connection with any new money financing (which is a typical feature in a financial restructuring), the directors will need to ensure the company can repay that new financing on its terms if they wish to be protected by the safe harbour regime.

Employee Entitlements and Tax Obligations

The third hurdle is created by the additional exemptions to the protection set out in section 588GA(4) of the Bill. Directors will not be able to rely on the safe harbour protection if the company has not made provision for the entitlements of its employees (including superannuation obligations) or is not compliant with its tax reporting obligations in a manner consistent with a company that is solvent.

It is not clear what making provision for entitlements involves but at the very least, it would seem to suggest that entitlements are up to date. Moreover, it is unclear what the purpose is of imposing a compliance standard consistent with a company that is solvent. Keeping employee entitlements up to date or compliance with tax reporting obligations do not form part of the definition of solvency in the Corporations Act, notwithstanding they are factors which are often present in companies with solvency difficulties.

According to a report published by the Australian Securities and Investments Commission in 2010, the majority of external administrations in Australia relate to small to medium proprietary limited companies. It is often a common feature in these administrations that the entities are non-compliant in the areas of employee entitlements and taxation and it is not unusual in these circumstances to see employees and the tax authorities being used as a secondary form of credit.

A key aim of the reform is to reduce the number of unnecessary external administrations for companies which could be successfully restructured. However, this is unlikely to occur if the directors of those organisations are unable to qualify for safe harbour due to the exemptions in proposed section 588GA(4). On the flip side and from a public policy perspective, these exemptions may provide the incentive to directors to make company compliance with employee and tax obligations a priority. It may also lead to directors seeking safe harbour protection earlier which may result in companies also taking the necessary course of actions earlier which ultimately improves the prospects of a successful business turnaround.

Continual satisfaction of safe harbour conditions

The final hurdle, and likely to be the stumbling block for a risk averse director, is the requirement to continually satisfy the conditions of safe harbour at all times during the restructuring process.

Restructurings can be lengthy processes where directors are required to make difficult decisions in often compressed time frames. If at any stage, the company fails to be compliant with respect to employee entitlements or tax reporting obligations, the safe harbour will fall away from that point. Moreover, if at any stage during the restructuring, it becomes clear that the company cannot be viable in the long term, the safe harbour protection will also fall away from that point. Only time will tell whether the distraction of continually monitoring compliance with the safe harbour provisions adversely affects the ability of directors to confidently lead their companies through restructurings.

There are many hurdles to jump for a director in seeking safe harbour during a restructuring process under the proposed legislation. In our view, far too many to take the reform as far as it needed to go to "encourage honest directors to innovate and take reasonable risks" in times of financial distress and crisis.

Alternative framework

In terms of an alternative approach, we question whether it would have been better and easier for the Bill to adopt similar language to that used in section 214 of the Insolvency Act 1986 (UK). That section frames its "wrongful trading" actions against directors by giving courts a discretionary jurisdiction to declare that a director of a company in insolvent liquidation or administration may be "liable to make such contribution (if any) to the company's assets as the court thinks proper". Such a declaration may be made if:

  • the court is satisfied that the director knew (or should have known) that, at some time before insolvency proceedings began, the company had no reasonable prospect of avoiding going into insolvent liquidation or administration; and
  • once it had become clear to that director that there was no longer a reasonable prospect of avoiding insolvent liquidation or administration, he or she did not take every step to minimise the potential loss to creditors that they should have taken.

This form of drafting is tried and tested in practice (especially the requirement to "take every step to minimise the potential loss to creditors") and has provided English company directors (as well as their restructuring and insolvency advisers) with the requisite latitude to implement informal restructurings for decades. This approach has less hurdles for directors to jump over yet maintains the requirement for creditors to be protected in restructuring situations, which is consistent with Australian case-law which requires directors to act in the best interests of creditors once the company is approaching (or has entered) the twilight zone.

IPSO FACTO REFORMS

The Bill also contains two new legislative provisions (sections 415D and 451E) to implement a stay on the operation of ipso facto clauses contained in commercial contracts.

An "ipso facto" clause gives one party a right to terminate or vary a contract upon the occurrence of a specific event, such as a counterparty entering into a scheme of arrangement or appointing a voluntary administrator. Generally such clauses operate regardless of whether the company experiencing financial difficulty has been performing its obligations under the contract.

The enforcement of these clauses has long been considered as a hindrance to the implementation of a consensual restructuring due to the limiting effect it has on the options open to the company, the potential destruction of enterprise value or the prevention of a sale of the business as a going concern.

The amendments introduced by the Bill will impose a stay on a party enforcing its contractual rights under an ipso facto clause solely because the other party enters into administration or a scheme of arrangement (but only where the company's scheme application states it is being made so the party can avoid being wound up in insolvency). Notably, the stay does not apply to liquidations or the appointment of receivers. The stay will only operate while the administration or scheme of arrangement is ongoing and will cease when the company is wound up.

The Bill also provides the court with power to order that any rights under a contract are only enforceable with the leave of the court and are subject to conditions imposed by the court. This order can only be made if the court is satisfied that, among other things, a party is exercising or will only exercise the contractual right because the counterparty has entered into a compromise or is in administration.

The overall effect of the amendments is to render unenforceable a clause that allows a party to terminate purely due to a counterparty entering into (or applying for) a scheme of arrangement, or entering into administration. When the legislation applies, the ipso facto clause will be unenforceable regardless of whether it is self-executing or takes effect at a party's election.

Under the Bill, a party cannot be forced to provide additional credit to the other party while the right to terminate or vary the contract is unenforceable. However, each party will still maintain its right to terminate or amend the contract for any other reason, such as a breach of the contract involving non-payment or non-performance.

Carve outs to the Amendments

The amendments will not apply to rights:

  • in types of contracts specified in regulations (which, according to a document released by Treasury, may include rights of set off, flexible priority arrangements, flawed asset arrangements, master netting agreements, and securitisation arrangements involving special purpose vehicles);
  • of a kind prescribed in a ministerial determination;
  • in agreements made after the commencement of a scheme of compromise or the date the company is placed into administration; or
  • that manage financial risk associated with a financial product that is commercially necessary for that type of financial product (e.g. swaps, where a party is entitled to close out its position so as to manage counterparty risk).

In addition, the Bill provides the court with discretion to lift the stay if:

  • it would be appropriate in the interests of justice; or
  • in the case of a scheme of arrangement, the scheme was not for the purpose of the company avoiding being wound up in insolvency.

OVERALL IMPACT

In our view, the restrictions on the enforcement of ipso facto clauses in the form set out in the Bill should be welcomed. They are likely to provide companies with the necessary breathing space they require when seeking to implement a financial restructuring plan.

As is often the case with complex financial restructurings (which seek to turn the company around rather than a terminal liquidation process), it is the financial debt (i.e. senior secured facilities, mezzanine facilities or high yield bonds) that is the cause of the company's financial problems rather than its trade creditor debt. It is generally the financial debt that is restructured (often via an equitisation process) that is the subject of a financial restructuring process. The success of the restructuring plan is often a function of the ability to keep as much of the business together as possible (while implementing a balance sheet fix and operational turnaround). A large part of that process is facilitated by maintaining key contracts to enable the business to run optimally and see it returned to profitability.

By limiting the ability of counterparties to terminate their contracts merely because the company has been placed into administration or is undertaking a scheme of arrangement (while providing contractual counterparties with appropriate protections), the new legislation should enable a company that has improved its financial health to emerge and continue to operate as a going concern. This, in turn, will directly benefit trade creditor counterparties by allowing the contracts to continue which should, all things being equal, lead to greater employment opportunities and mutually beneficial outcomes.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Chambers Asia Pacific Awards 2016 Winner – Australia
Client Service Award
Employer of Choice for Gender Equality (WGEA)

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions