Insolvency reform: more equity for directors and less equity for shareholders?

Summary

In an exciting week for insolvency, the Minister for Financial Services, Superannuation and Corporate Law has released a package of reforms to Australia's corporate insolvency laws. This reform package includes:

• an amendment to the Corporations Act 2001 to reverse the effect of the High Court's decision in Sons of Gwalia;
• the release of a discussion paper on possible reform of Australia's insolvent trading laws, aimed at providing alternatives to external administration for directors attempting to rescue businesses in financial difficulty; and
• the adoption of substantially all of the recommendations made by the Corporations and Markets Advisory Committee (CAMAC) in its "Issues in external administration" report.

The reversal of the High Court's decision in Sons of Gwalia, and the potential for an expansion of the business judgment rule to insolvent trading, would bring these Australian laws more into line with the applicable American laws.

Reversal of Sons of Gwalia

The reversal of the High Court's 2007 decision in Sons of Gwalia would bring Australia's present equation of shareholder damages claims with creditors' claims into line with the United States, where claims made by a shareholder associated with the purchase of shares are subordinated to the claims of general unsecured creditors.

The reversal of the decision in Sons of Gwalia will likely have the effect of:

• returning certainty to external administration;
• encouraging debt investment in Australia;
• limiting some concern of banks at unsecured debt exposures and reducing lending costs;
• reducing insolvency administration costs;
• reducing class actions available to shareholders and litigation funders; and
• restoring protection to debt markets ahead of equity markets
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Reform of insolvent trading laws?

Section 588G of the Corporations Act 2001 provides that a director can be held personally liable for debts which a company incurs when the director knew or ought reasonably to have suspected that the company was insolvent or would become insolvent. Concerns with this are:
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• directors may feel compelled to appoint a voluntary administrator based on a fear of personal liability for the debts of the company incurred whilst it is insolvent;
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• the best interests of the company's members or creditors may not be served by the premature appointment of an external administrator; and
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• the defences of expectation of solvency, reliance on an appropriate professional and acting honestly are difficult to establish.

The discussion paper aims to address concerns raised by directors that Australia's insolvent trading laws may prevent them from implementing genuine workout strategies for fear of personal liability for insolvent trading. Australia has some of the most onerous insolvent trading laws in the world.

The options proposed by Treasury for discussion are:

• maintain the status quo;
• implement a modified version of the business judgment rule; or
• allow directors a moratorium from insolvent trading laws for a limited period whilst they attempt to reorganise the company.

A modified business judgment rule?

This rule is already contained in the Corporations Act 2001 in relation to a director's statutory duty of care and diligence under section 180 of the Corporations Act 2001, and the equivalent duties at common law and in equity.

An expansion of the business judgment rule would operate to relieve a director from liability for insolvent trading where the following proposed elements are satisfied:

• the company's financial records were fair and accurate;
• the director took restructuring advice from an appropriately qualified professional, who had access to the books and accounts of the company, on the feasibility of and means for ensuring the continued solvency of the company;
• it was the director's business judgment that the interests of the company's creditors and members were best served by pursuing the restructure; and
• the restructuring was diligently pursued by the director.

The discussion paper outlines concerns that this process might be subject to abuse, and that it places no obligation on directors to consider options to maintain solvency during a workout, and thus avoid trading whilst insolvent.

An expanded version of the business judgment rule would bring the position in Australia closer to that of the United States, where personal liability is not imposed on directors for insolvent trading where they are acting honestly and carrying out their fiduciary duties to act with care in the best interests of the company.

A moratorium on insolvent trading laws?

This moratorium would be of a limited duration, and would not apply to dishonest trading. In order to invoke the proposed moratorium:

• a company would need to inform the market, including existing and potential creditors, that it was insolvent and intended to pursue a workout outside of external administration; and
• directors may potentially be required to form a rational opinion that the company is currently or is in imminent danger of becoming insolvent, or alternatively, that it is in the interests of creditors as a whole that attempts to reorganise the company be made outside the external administration regime.

Creditors would have a say in the duration of the moratorium, and the courts may be the final arbiter of any dispute as to the duration of the moratorium. The effect that any moratorium might have on existing contracts is uncertain, and would not address the operation of any termination on insolvency clauses in contracts to which the company is a party.

Streamlining external administration

Drawing on recommendations made in CAMAC's November 2008 report "Issues in external administration", the reforms outlined include:

• facilitating the electronic provision to creditors of creditor lists and aligning the relevant provisions for most kinds of corporate insolvency administration;
• providing certain information to owners of property in the possession of a company in external administration;
• introducing voting on certain proposals without the need to hold creditors' meetings;
• mandating the requirement to notify creditors of material breaches of deeds of company arrangement;
• streamlining creditor meeting procedures;
• streamlining the approval of provisional liquidator remuneration and the appointment of replacement external administrators in the event of a vacancy;
• facilitating the future development of alternative methods of publication of certain insolvency related events;
• empowering the Australian Securities and Investment Commission (ASIC) to take and transfer possession of records in the event of a vacancy in the external administrator;
• aligning the rules regarding disclosure of former names of a company between the different kinds of external administration; and
• reducing the regulatory burden upon insolvency administrations in relation to the provision of notices to creditors.

These reforms are designed to reduce the cost and complexity of the administration of an insolvent estate, to improve communications with creditors and reduce the potential for abuse of corporate insolvency law.

The reforms are also proposed to remove anomalies in the 'relation-back' and 'commencement' dates for liquidations, to eliminate potential manipulation of how far back corporate insolvency claw back provisions apply.

Timing

These reforms will take some time to implement. Legislation reversing the decision in Sons of Gwalia is yet to be introduced into the House of Representatives, and whilst statements made by the Opposition suggest the bill will receive bipartisan support, there will be some delay before introduction as the bill makes its way through the House of Representatives and the Senate.

The broader reforms to the Corporations Act to streamline the external administration process are likely to be subject to similar timing.

The discussion paper on insolvent trading is at the submission stage. Whilst this is an early stage of the process toward any reform, submissions are due by 2 March 2010. It is likely that, once the report has been finalised, any reform would take place 12 months later, having regard to timing on recent CAMAC report adoptions.

Implications for insolvency practitioners

Should a modified business judgment rule be adopted to address concerns about insolvent trading laws, insolvency practitioners may balance lost voluntary administration and liquidation work with increased restructuring work.

Any director seeking to utilise the business judgment rule would be required to take restructuring advice from an appropriately experienced and qualified professional as to the ongoing and projected solvency status of the company through the workout.

Should a moratorium be introduced, it is likely that, in seeking to utilise any moratorium, a director would be well advised to seek advice from an insolvency practitioner:

• in forming their "rational opinion" as to the future prospects of the company, or the interests of creditors; and
• chairing meetings of creditors.

Insolvency practitioners will need to be particularly careful not to overstep their role as an advisor and risk becoming an officer of the company. Whether insolvency practitioners may then face a conflict of interest in accepting a formal appointment to those companies they assisted will require further reflection and clarification in legislation.

Insolvency practitioners may save time at the proof of debt adjudication stage when Sons of Gwalia is overturned, as they will be entitled to reject claims made by certain shareholders. It is unclear from the present proposal whether liquidators or deed administrators will be required to subordinate shareholder damages claims to creditors' claims:

• from a future date to be announced by parliament;
• in respect of claims by shareholders not yet submitted; or
• in respect of insolvency administrations yet to be commenced.

Taken with the proposed general external administration streamlining, insolvency practitioners may face reduced administrative obstacles and expenses in discharging their duties. They may also face exciting new challenges as the possibilities for being engaged by directors for restructuring are brought more into line with the rest of the corporate world.

Implications for directors

The proposed reforms to Australia's insolvent trading laws should provide more flexibility for directors of companies in financial difficulty when trying to effect a workout.

A modified business judgment rule would allow directors to undertake a restructure of an insolvent company, provided certain legislative criteria are satisfied. When seeking to utilise the business judgment rule, a director must take restructuring advice from an appropriately experienced and qualified professional as to the ongoing and projected solvency status of the company through the workout.

A moratorium on liability for insolvent trading would allow a director to work with the company's creditors in certain circumstances to restructure the company. Again, a director should seek advice from "an appropriately qualified professional" (most likely an insolvency practitioner):

• in forming a "rational opinion" as to the future prospects of the company, or the interests of creditors; and
• chairing meetings of creditors.

The reversal of the Sons of Gwalia decision should reduce the cost of credit to business through increased certainty as to the ranking of debt and equity creditors, and the cost and complexity of any administration of an insolvent estate.

Directors may be provided with more flexibility to restructure financially troubled companies, and reduced liability for insolvent trading claims. They may also be able to effect creative restructures of financially troubled companies that are currently risky under Australia's onerous insolvent trading laws.

The proposed reforms still leave much unsaid about how they will operate in practice. Norton Rose Australia will provide you with further updates on the progress and practical ramifications of the reforms.

For an overview of a largely unexplored potential safe harbour from insolvent trading under s 1317S of the Corporations Act 2001, see David Goldman, A safe harbour from insolvent trading? (Australian Financial Review: Dealbook, www.afr.com, 15 December 2009).

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.