KEY TAKE OUTS
- Insolvency reforms at a glance.
- Introducing a safe harbour from personal liability for directors for insolvent trading if they appoint a restructuring adviser to develop a turnaround plan for the company.
- Making ipso facto clauses, which allow contracts to be terminated solely due to an insolvency event, unenforceable if a company is undertaking a restructure.
- Reducing the current default bankruptcy period from 3 years to 1 year.
Australia’s formal insolvency processes are generally considered to destroy enterprise value. Accordingly, there have been an increasing number of insolvency practitioners and industry representative bodies calling for reform to Australia’s insolvency regime to promote a stronger restructuring culture and to encourage businesses to seek professional guidance before succumbing to higher levels of financial distress.
Consistent with this strong sentiment for policy reform, and following years of consideration and debate in the industry, the Productivity Commission in its final report released on 7 December 2015 (Business Set-Up, Transfer and Closure) made a number of recommendations for reform of the existing regime.
Following on from the publication of the Report, the Federal Government issued its Innovation Statement which included a number of proposals for insolvency law reform drawn from the Commission’s recommendations. Specifically, the Government is proposing to introduce a ban on enforcement of ipso facto clauses if the company is undertaking a restructure, to offer a ‘safe harbour’ for directors if they appoint a restructuring adviser to develop a turnaround plan, and to provide a reduction in the current default bankruptcy period from 3 years to just 1 year.
The precise nature of the proposed reforms has yet to be revealed (a proposal paper is to be released by June 2016), however given the comprehensive nature of the Commission’s inquiry one would expect the Government to adopt the actual measures proposed by the Commission.
In this article, we consider the proposed reforms in relation to safe harbour and the prohibition on the enforcement of ipso facto clauses.
Providing a safe harbour
Currently under Australia’s company laws, a company that becomes insolvent is required to immediately cease trading. There is no scope under the current regime for directors to seek to make informal attempts to restructure a company that is insolvent.
Any director in breach of this obligation faces civil liability for the debts incurred by the company and, in certain circumstances, the risk of imprisonment. Therefore, when the prospect of insolvency arises, directors are effectively obliged to place a company into external administration in order to avoid insolvent trading liability.
Amendment to the regime to create a safe harbour is necessary to provide directors with a genuine opportunity to engage with key stakeholders with a view to implementing a restructure.
The voluntary administration process, which was intended to provide directors with an opportunity to rescue the company, does not generally provide this. Indeed, it often signals the death of the company. The damage, and in some cases destruction, of the value of the enterprise caused by placing the company into external administration undermines the prospects of the implementation of a successful restructuring.
The Commission noted in its Report that the insolvent trading provisions act as a strong disincentive for directors to take what could otherwise be appropriate risks to attempt to restructure the company.
It considered that the solution to this problem is to create a regulatory system that enables company directors to make informed decisions, free of any distorted incentives and undue influences, such as fear of personal liability.
Prior to the publication of the Report, the debate in relation to amendments in this area had primarily focused on two possible options for reform.
Firstly, the creation of an additional business judgment rule defence to an action for insolvent trading. Secondly, permitting directors to have the benefit of a moratorium from insolvent trading laws in order to pursue an informal workout. Notwithstanding this, the Commission proposed an alternative form of safe harbour, namely that the Corporations Act 2001 (Cth) be amended to provide a defence which is available when the:
- Directors have made, and documented, a conscious decision to appoint a restructuring adviser with a view to implementing a turnaround plan;
- Adviser is provided with proper books and records upon appointment;
- Company is solvent at the time of the appointment;
- Adviser is registered and has at least 5 years’ experience as an insolvency and turnaround practitioner;
- Directors diligently pursue the restructuring; and
- Advice must be proximate to a specific circumstance of financial difficulty, and subject to general anti-avoidance provisions to prevent repeated use within a short period.
It envisaged that the defence would provide cover for the running of the company from the time of appointment until the conclusion of the implementation of the restructuring advice.
Furthermore, the Commission recommended that the appointed adviser be obliged to terminate the safe harbour period and advise the directors to appoint an external administrator in the event that a viable restructure is no longer possible.
Ipso facto clause
Under the existing insolvency regime in Australia, there is no prohibition or moratorium on enforcement of ipso facto clauses (i.e. contractual clauses which allow one party to terminate an agreement by reason only of the fact of the insolvency of the other party).
Where such clauses exist, the appointment of an administrator to a financially distressed company can result in the company’s counterparties invoking their right to automatically terminate the contracts, even though there is no other breach of the contract. The result? There is no business to restructure, the value of the company’s goodwill plummets and there is no longer any going concern for creditors.
The primary policy objectives behind Part 5.3A of the Corporations Act are, in principle, to facilitate and maximise the chances of a business continuing to exist, despite financial distress.
However, where ipso facto clauses are present in valuable contracts, these primary policy objectives may not be achieved as the business operations of the company can be prematurely extinguished, notwithstanding that the business is capable of carrying on.
For this reason, many insolvency practitioners, lawyers and industry representative bodies have for some time called for a complete prohibition on enforcement of ipso facto clauses in Australia.
In its Report the Commission noted that the operation of these clauses severely reduces the scope for a successful restructure of a business. It therefore recommended that the Act be amended to make such clauses unenforceable if a company is undertaking a restructuring. It also recommended that the prohibition operate until a liquidator had been appointed.
The Commission considered that there is no need to implement an ipso facto moratorium in relation to safe harbour in circumstances where, consistent with the Commission’s recommendation, the safe harbour is implemented as a defence rather than a process. The private nature of the defence obviates the need for the moratorium on the basis that counterparties who are not directly involved in the restructuring will remain unaware that the company is actually in safe harbour.
Business value should be preserved
The overwhelming majority of foreign jurisdictions have laws that facilitate attempts at informal restructuring or at the very least do not discourage it. Australia’s current insolvency regime is regarded by many industry experts and commentators as overly legalistic in some respects, with a strong bias towards preserving creditors’ rights.
There is strong merit to the argument that changes need to be made to promote the preservation of business value in informal processes and to improve genuine opportunities for business rehabilitation.
The reforms proposed by the Government are long overdue. The changes are to be welcomed in principle but, as they say, the devil will be in the detail. It is critical that the reform measures strike an appropriate balance between providing support for genuine attempts to restructure businesses in financial distress and protecting the company and creditors from reckless and/or unscrupulous actions.