Australia: Law reform: the new safe harbour for directors and stay on enforcement of ipso facto clauses

Australian insolvency laws recently underwent the most comprehensive review and reform since the early 1990s.

Despite some calls for an overhaul of the Australian insolvency regime to replace it with a Chapter 11 style equivalent, we settled for a swathe of reforms aimed at, on the one hand, improving efficiencies in the formal insolvency processes and, on the other hand, promoting a culture of entrepreneurship.

This article will focus on the latter of these reforms—the introduction of the safe harbour and ipso facto reforms.

The reforms are aimed at fostering a culture of restructuring in amidst an insolvency regime that imposes tough penalties on directors that continue to trade a company while it is insolvent. Such is the concern around penalties that it is often the case that directors will act early to appoint an insolvency practitioner to the company at the expense of exploring viable restructuring options.

The legislature hopes that a move away from a focus on "stigmatising and penalising failure" will follow introduction of the new 'safe harbour' provisions and the stay on the exercise of the so called 'ipso facto' rights in certain circumstances.

While the law reforms apply to Australian companies and directors, they present significant benefits for foreign stakeholders who may, in a distressed scenario, be able to support the company through the period of financial distress, or effect a refinancing or achieve a pay out at a higher return than otherwise would have been available in liquidation. Arguably, to date, the scope for such better commercial outcomes has been significantly restricted.

A side note: the term "safe harbour" as used in Australia is not to be confused with the meaning of that term in the US. That is, the safe harbor provisions under Section 546(e) of the US Bankruptcy Code protect defendants from anti avoidance suits. In Australia, the term 'safe harbour' is a quasi-defence for directors against the statutory duty to prevent a company trading while insolvent.

The new 'Safe Harbour' for directors

What is insolvent trading?

The Corporations Act 2001 (Cth) (Corporations Act) imposes a duty on directors to prevent a company from incurring a debt (or debts) when the director has reasonable grounds to suspect the company is, or may become, insolvent. Under Australian law, a company is considered to be insolvent when it is unable to pay its debts as and when they fall due and payable.

Although there are some defences available to a director, liability for insolvent trading under Australian insolvency laws can expose a director to a range of penalties including civil or criminal penalty orders or orders for compensation to creditors who suffered loss. It is not uncommon for management liability policies (e.g., Director and Officer Policies) to exclude claims relating to insolvent trading from the scope of the indemnity. Consequently, insolvent trading claims can expose directors to bankruptcy and loss of personal assets if they do not have the financial capacity to satisfy any monetary judgment entered against them.

Introduction of safe harbour provisions

Successful insolvent trading claims are rare. However, it was recognised by the Federal Government that:

The threat of Australia's insolvent trading laws, combined with uncertainty over the precise moment a company becomes insolvent, have long been criticised as driving directors to seek voluntary administration even in circumstances where the company may be viable in the longer term.

It was also recognised that Australia's insolvency laws:

  1. can discourage directors to be innovative or take reasonable risks to restructure or trade the company out of its financial difficulties due to concerns about personal liability;
  2. penalise failure, particularly in circumstances when a director may have otherwise been acting honestly and in good faith;
  3. have the potential to unnecessarily affect the enterprise value of a business when a voluntary administrator is appointed prematurely, particularly in circumstances where there may be the ability to turnaround or restructure the business it can continue; and
  4. can result in companies being placed into liquidation unnecessarily due to the loss of confidence of stakeholders in the business following the appointment of an administrator.

The safe harbour reforms introduced into the Corporations Act came into effect on 19 September 2017. The amendments are designed to:

  1. drive cultural change in the boardroom by encouraging directors to keep control of their company (instead of appointing an insolvency practitioner);
  2. encourage directors to engage with stakeholders early when possible insolvency is suspected; and
  3. encourage directors to focus on reasonable rescue and turnaround efforts, rather than taking a traditionally conservative approach and placing the company into voluntary administration.

Safe harbour and the concept of a 'better outcome'?

In effect, the amendments give directors a safe harbour from the civil insolvent trading provisions contained in section 588G of the Corporations Act whilst attempting to restructure or turnaround the business.

The safe harbour provisions apply if (and subject to certain conditions being met) after the director starts to suspect the company is or may become insolvent, the director starts to develop "one or more courses of action that are reasonably likely to lead to a better outcome for the company." The period of safe harbour continues from the time at which the director starts to develop the course of action and ends at the earliest of any of the following times:

  1. the director fails to take steps to implement the proposed course of action within a reasonable period of development (What is a "reasonable period" for development will depend upon the particular circumstances. However, conscientious attention to developing the plan in an expedient manner is expected.);
  2. when the director ceases to take any such course of action;
  3. when the course of action ceases to be reasonably likely to lead to a better outcome for the company (Directors should closely monitor the course of action to ensure that the course of action developed is not carried out beyond the point at which it can said to still be reasonably likely to lead to a better outcome.); or
  4. an administrator or liquidator is appointed to the company.

A "better outcome" is defined in the legislation to mean "an outcome that is better for the company than the immediate appointment of an administrator or liquidator of the company". This test necessarily requires both a comparison of the return to creditors in an immediate insolvency versus a later insolvency and an assessment of the impact on other stakeholders, such as employees and shareholders.

Significantly, the plan developed and implemented by the director does not need to succeed in order for safe harbour protection to apply. It is possible that the course of action will result in a worse outcome for the company than if an administrator or liquidator was appointed immediately upon insolvency having been suspected. However, the safe harbour protection will still apply to the debts incurred by a director during that period so long as the course of action was still likely to lead to a better outcome at the time the decision was taken.

Consequently, a director seeking to rely on the safe harbour provisions should document the proposed course of action including identification of the assumptions behind the plan, provision of an explanation for why the plan is likely to result in a better outcome and specification of a clear set of steps required to implement the proposed course of action, together with a timetable of milestones capable of assessment.

The legislation specifies five factors (although, without limitation) that a Court may consider in determining whether a course of action is "reasonably likely to lead to a better outcome", when safe harbour is asserted in proceedings. That is, whether the director is:

  1. properly informing himself or herself of the company's financial position; or
  2. taking appropriate steps to prevent misconduct by officers or employees of the company that could adversely affect the company's ability to pay all its debts; or
  3. taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company; or
  4. obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice (An "appropriately qualified entity" is not defined in the legislation. However, an accountant, lawyer or other specialist with skills in turnarounds or restructures is likely to satisfy this test.); or
  5. developing or implementing a plan for restructuring the company to improve its financial position.

The factors are not mandatory and not all factors need necessarily apply in order for a director to have the protection of safe harbour. However, best practice requires attention to each matter raised when seeking to rely on the safe harbour provisions.

Conditions to safe harbour

There are certain conditions to the operation of the safe harbour provisions, which are designed to ensure that safe harbour protects those directors who act "honestly and diligently":

  1. the debt must be incurred directly or indirectly in connection with the proposed course of action. The debt can include ordinary trade debts incurred in the usual course of business or debts taken on for the specific purpose of effecting the plan (including debts incurred in connection with a restructure or loss-making trade), but will not include debts outside this purpose or incurred for an improper purpose;
  2. the company must continue to pay all employee entitlements (including superannuation) as and when they fall due; and
  3. the company must continue to comply with all tax reporting obligations.

Further, the protection provided by the safe harbour provisions does not extend beyond protecting a director from civil liability for insolvent trading. During the safe harbour period, directors must continue to comply with their other legal obligations, for example director duties to act in good faith and the best interests of the company.

In addition, the safe harbour protections do not prevent the appointment of an insolvency practitioner (including an administrator, liquidator or receiver) by a third party during the safe harbour period.

Finally, a company listed on the Australian Securities Exchange (ASX) must comply with any continuous disclosure obligations. The ASX has issued guidance, which clarifies that the fact an entity's directors are relying on the safe harbour provisions is not, in and of itself, a matter the ASX would require an entity to disclose.

Stay on enforcement of ipso facto clauses

Typical ipso facto clauses in commercial contracts

Ipso facto—or by the fact itself—is a term used to describe clauses in commercial contracts that provide a party with certain rights (including termination) upon the occurrence of a specific event. The right may be exercised regardless of the counterparty's continued performance of its obligations under the contract.

Commercial contracts typically include ipso facto clauses that give a party a right to immediately terminate the contract upon the occurrence of an 'event of default' or an 'insolvency event'. For example, such rights may allow one party to terminate or modify the contract solely due to the financial position of the company or due to the commencement of a formal insolvency process.

A typical termination clause in a contract may take the following form:

Without limiting any other right A may have under this agreement or otherwise at law, A may terminate this agreement by notice in writing to B if an Insolvency Event occurs in respect of B.

An Insolvency Event is often defined to include circumstances where a company is subject to a scheme of arrangement with creditors, has a receiver or receiver and manager appointed to all or part of its property, or enters into voluntary administration.

Ipso facto clauses are not limited to termination rights. They may include clauses that, upon the occurrence of an event, give a party the right to charge higher interest, automatically change the priority waterfall or allow a party to assign or novate the contract.

Motivation for change—why stay a party's ability to exercise its rights?

The legislature takes the view that the ipso facto clauses reduce the scope for a successful restructure or prevent the sale of business as a going concern. The stay is intended to assist viable but financially distressed companies to continue to operate while they restructure.

The stay also promotes the first objective of the voluntary administration regime—for the business, property and affairs of the insolvent company to be administered in a way that "maximises the chance of the company, or as much as possible of its business, continuing in existence."

The scope of the "ipso facto" stay

The so called 'ipso facto' provisions commence on 1 July 2018 and apply to contracts entered into on or after 1 July 2018.

The new ipso facto provisions were introduced under the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth) by way of an amendment to the Corporations Act, being the statute that governs insolvency processes in Australia, amongst other things.

The provisions impose a stay on enforcing rights merely because of the financial condition of the company or because the company is in voluntary administration, receivership or subject to a deed of company arrangement. Necessarily, the stay does not apply if a resolution or Court order has been made to wind up the company.

The provisions also impose a stay on self-executing clauses, being those clauses in contracts that start to apply automatically upon the occurrence of a certain event and without any party making a decision that the provision should start to apply.

Importantly, the stay does not prevent a counterparty from terminating a contract for reasons unrelated to the financial condition or insolvency of the company (e.g., for non-performance of an obligation). However, where a party has not exercised its termination right prior to the insolvency of a company, it may be difficult to establish that the reason for enforcing that right is for anything other than the financial condition or insolvency of the company.

The stay is not a blanket stay. A number of rights, self-executing clauses and contracts are excluded from the operation of the stay, reflecting that there is a variety of situations where the stay on ipso facto clauses is unnecessary or undesirable. More on the exclusions later.

In addition to certain exclusions applying, counterparties may obtain the consent of the receiver or voluntary administrator to exercise its ipso facto rights or an order from the Court that the stay does not apply, provided the Court is satisfied that it is appropriate in the interests of justice to do so.

Furthermore, although contracts will remain on foot, a counterparty is not required to continue to advance new money or credit to an insolvent company. So, if you are an investor who has provided finance to the company, you will not be required to make any further advances, although the financing agreement will remain on foot.

The exclusions—when is a party not bound by the stay

At the time of writing, the legislature had released draft regulations prescribing the relevant exclusions for the purposes of the ipso facto reforms. Following consultation with industry groups and professionals, we expect the draft regulations will change, albeit the general tenor of the exclusions is expected to remain.

The exclusions are aimed at certain arrangements where the inability of a party to exercise ipso facto rights or the stay on the operation of self-executing clauses may disrupt markets or undermine complex financial products, or would lead to a perverse outcome.

Examples of rights and self-executing provisions that are proposed to be excluded from the operation of the stay, such that parties may continue to rely on such clauses notwithstanding the financial condition or insolvency of a company, include:

  • the right to charge higher interest rates and enforce indemnities for costs in financing arrangements;
  • the right to terminate forbearance or standstill arrangements (Such arrangements are considered integral tools that assist restructurings. The failure to exclude such rights may act as a disincentive for parties to take that initial step, thereby making it difficult for a financially distressed company to create a stable platform from which it can explore restructuring options.);
  • the automatic operation of 'flip clauses' that work to change the priority waterfall;
  • the exercise of set-off and netting rights and rights of assignment and novation;
  • the operation of self-executing provisions that relate to circulating security interests (i.e., floating charge assets);
  • the exercise of step-in rights that are typically contained in construction contracts or long term service contracts (Such step-in rights provide for another person to 'step in' and perform the contract in the event of the insolvency of the of one party.); and
  • the right to appoint a receiver in circumstances where the party has a security interest in the property of the company and a controller has already been appointed to the property of the company (This exclusion is aimed at ensuring that rash decisions are not made to appoint receivers if there are several parties with such rights).

The draft exposure regulations also carve out of the stay certain types of contracts, including contracts that relate to financial products (including derivative, underwriting and subscription contracts, rights issues, margin lending facilities and bonds), arrangements to sell all or substantially all of the company's business, netting arrangements, subordination, flawed asset and factoring arrangements and arrangements relating to clearing and settlement facilities, to name a few.

Interestingly, the draft regulations also exclude from the stay arrangements to which a special purpose vehicle (SPV) is a party. Although the legislature intends this to capture securitisation arrangements, it has attracted criticism as being too broad. The concern is that it will see a practice develop of using SPVs so as to circumvent the stay (and we query whether the anti-avoidance provisions would be sufficient to guard against such structures).

We expect the final form of the regulations to be released in a short time, and before 1 July 2018.

What this means for counterparties

The continued performance of contracts while a company undertakes a restructuring (albeit through a formal insolvency procedure) is hoped to have the effect of enabling the company to continue into the future and thereby limit the flow on effects to its counterparties.

As we stated above, the stay only applies to contracts entered into on or after 1 July 2018. While the reforms include anti-avoidance restrictions to prevent parties from contracting out of the operation of the stay, parties may consider varying contracts rather than entering new contracts, although a substantial variation may, under Australian law, be deemed to be a new contract.

Conclusion

It is hoped that the law reforms have the intended effect—to develop a culture of restructuring in Australia so that investors—foreign and domestic—have an opportunity to obtain a better outcome in the event that a company is in financial distress.

There is a school of thought that there ought to be a complete overhaul of Australia's insolvency regime to further promote the culture of restructuring. A missed opportunity or not, the reforms provide a necessary step in the right direction.

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.

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