How an SBR can protect directors' exposure to an insolvent trading claim
A new safe harbour carve-out
In early 2021, as part of the adoption of the small business restructuring (SBR) reforms, a new safe harbour carve-out was introduced to the Corporations Act 2001, making SBR an eligible safe harbour plan. 1
This article discusses the drawback of traditional safe harbour protection for SMEs and explains how an SBR can offer directors a safe harbour protection against a potential insolvent trading claim that is often not well-understood.
Safe harbour: A shield against insolvent trading claims
The safe harbour protection mechanism, which came into effect in September 2017, aims to encourage an entrepreneurial and innovative environment and provides protection to directors of financially distressed companies against insolvent trading claims.
Previously, to obtain a safe harbour protection, the directors will need to take actions that are "reasonably likely to lead to a better outcome for the company" which require them to:
- take steps to keep themselves informed about the company's financial position;
- take appropriate steps to prevent company officers' and employees' misconduct;
- ensure the company maintained appropriate financial records;
- obtain advice from an appropriately qualified entity; and
- document their course of action and ensure that the company pays all employee entitlements and keeps its tax lodgements up to date.
Traditional issues for SMEs seeking safe harbour protection
Notwithstanding the protection provided by law, small businesses had rarely considered safe harbour advice, due to a variety of reasons, including:
- large corporations possess greater resources to undergo restructuring such as more assets to sell, more flexibility in reducing costs, and implementing strategic changes;
- small businesses generally face difficulties in affording the expenses associated with restructuring, formal or informal, including obtaining safe harbour advice which can be relatively expensive;
- directors of small businesses may be personally responsible for the debts they guaranteed, such as leases for property and equipment, in addition to any claim of insolvent trading.
Thanks to the new safe harbour regulations, SMEs undergoing an SBR process now automatically have access to safe harbour provisions which limits the value/quantum of potential insolvent trading claims.
The SBR process
SBR has become a popular option for struggling businesses seeking to restructure their debts and avoid liquidation.
Compared to a voluntary administration, an SBR typically offers a more expedient and cost-effective means of debt restructuring for a company, while allowing its directors to retain control over the company's operations.
During an SBR process, the director works with an SBR practitioner to develop a restructuring plan that is likely to result in a better outcome for the company and its creditors than liquidation. Typically, the plan proposes a certain percentage of the outstanding debt to be paid to creditors as a compromise. With the SBR practitioner's endorsement, the restructuring plan is presented to the creditors, and if approved, all eligible creditors2 will be bound by the plan.
Risks involved in SBR and limitation of safe harbour protection
Importantly, the SBR process does not guarantee success either in the short- or long-term. If the restructuring ends for any reason other than an approved restructuring plan being completed in accordance with its terms, it is likely that the company will end up in liquidation.
While directors seeking to restructure a company's debt via an SBR should not refrain from appointing an SBR practitioner out of fear of facing an insolvent trading claim3 as explained in this article, one should note that this protection does not eliminate the risk of a claim altogether, it may limit the amount of any potential claim.
It is crucial for directors to seek professional advice and carefully consider all their options before deciding to engage an SBR practitioner.
1 Section 588GAAB of the Corporations Act 2001, provides that the duty to prevent insolvent trading does not apply to debt incurred by a company during the restructuring.
2 Some creditors may not be bound by a restructuring plan, for example, secured creditors can take enforcement action against security/property if it begins before appointment of RP (section 454D of the Act). Also, creditors that are related to the company do not get to participate in SBR process.
3 When a restructuring plan is sent to creditors the company is deemed insolvent (Section 455A of the Insolvency Reform Bill).
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.