A central focus of insolvency law is the preservation of enterprise value. While it is generally recognised that Australia’s formal insolvency processes are world class on this measure, the same cannot be said of the legal framework underpinning our equally important informal processes − restructurings and workouts.
These informal processes are particularly important with public companies and other large enterprises, where a financially troubled balance sheet may well be capable of being remedied by agreement between the company and its bankers, bondholders or investors.
Alternative options such as formal insolvency processes can damage and sometimes destroy the value of an enterprise. Other avenues like administration invariably trigger defaults in commercial agreements.
The flow-on effects of these alternatives such as competitors poaching the company’s customers, the connotations of a “fire sale” associated with any sale of the company’s assets, and the loss of consumers who may shun the brand due to concerns about future service or warranty issues, significantly contribute to the devaluation of a company under stress.
For these reasons, when large enterprises have their solvency brought into question, it is highly desirable to attempt, where feasible, a restructuring rather than immediately appointing administrators. If successful, more employees keep their jobs, ordinary creditors generally continue to receive payments and other stakeholders benefit.
The rest of the world has laws that facilitate such an approach, or which at the very least do not discourage it. Australia, however, is out of step as our laws provide a number of significant impediments.
In Australia it is unlawful for directors to make informal attempts to restructure a company that is insolvent. Instead they must cease trading immediately or place the company into a formal administration process. The law operates in this way even when professional advice to the directors is that a restructuring is feasible and, if successful, would be for the benefit of employees and creditors. Any director breaching this law faces personal liability for the debts being incurred by the company, and in some circumstances, imprisonment.
Even where the company has simply had its solvency brought into question, it is a brave director who continues to put the interests of the company’s creditors ahead of her or his own liability risks.
With the exception of New Zealand, no other country has a law that operates in this way. This was not always so. Germany had an insolvent trading law of similar severity but in late 2008, the German Government suspended that part of the law as part of its emergency measures to address the global financial crisis.
The discussion paper issued by Minister Bowen raises three options for consideration in the insolvent trading sphere. The first option is that there is no change to the law. The second option provides an additional business judgement rule defence to an action for insolvent trading. The third option is to permit directors to have the benefit of a moratorium from insolvent trading laws provided the company informs the market that it is insolvent and intends to pursue a workout outside of external administration.
On the first option − the status quo − do we really think Australia is right and the rest of the world has got it wrong? Like everywhere else in the world, directors must be permitted to pursue proper restructuring opportunities outside of a formal insolvency appointment where, with the benefit of professional advice, they honestly and reasonably believe that this is in the best interests of the financially distressed company
and its creditors. Of the two alternative options, it is significant that the prohibition against insolvent trading is not being abolished. The alternative options simply identify confined and specific circumstances where
the prohibition would not apply, to enable the company’s financial difficulties to be appropriately addressed.
In the discussion paper, options two − business judgement defence, and three − moratorium, provide alternative reforms. However, it is suggested that the moratorium proposal would not work in practice. In any event, it is less desirable from the perspective that it would remain open for abuse.
A major impediment with the moratorium proposal is that to declare to the world that the company is insolvent would be to invite creditors to line up at the gates and suppliers to withhold supply. It would be entirely inappropriate for directors to subject their company to this damage unless it was clear that it was insolvent.
Experience suggests this is rarely black or white. So if there was simply a question mark over the company’s solvency, or a concern that the company may soon become insolvent, it would be entirely inappropriate for directors to harm the company in this way. Yet, by not making the declaration of insolvency, they would still face the very real risk of insolvent trading liability where grounds exist for suspecting that the company was insolvent.
To issue a declaration too early would harm the company and perhaps make a formal appointment more likely. But not to do so, would leave directors unprotected from the existing laws.
The moratorium proposal is also problematic from the perspective that a declaration of insolvency would be likely to trigger ipso facto clauses in the company’s commercial agreements, permitting those agreements to
be cancelled, which could also lead to irreparable harm and damage. The proposal would also be subject to abuse. In the case of large enterprises, there would be no ability for creditors to make properly informed views about whether to support or to end the moratorium.
It is suggested that option two, being the creation of a modified business judgement rule defence to an insolvent trading action, is the preferred approach. It is important to observe that the proposed defence does not simply require the director to form a business judgement that the company should continue to trade. There is a number of proposed objective criteria that would need to be established as well. These criteria include that the company’s financial accounts were accurate, professional restructuring advice was being taken from an appropriately experienced and qualified professional with access to those accounts and that the restructuring was being diligently pursued. It is considered that this test appropriately strikes the balance between protecting creditors and other stakeholders by preventing losses that arise from insolvent companies continuing to trade, and not impeding proper attempts by honest directors to pursue workouts and other restructuring options to return the company to a state of solvency. It is perhaps best tested by asking two questions.
First, if such a defence is introduced, will honest, diligent directors now feel able to pursue proper attempts at restructuring? Secondly, will imprudent, reckless or dishonest directors be able to escape responsibility for insolvent trading liability by the availability of this defence?
On the first question, the defence would appear to mirror what a prudent, honest director would do – ie ensure accounts are accurate, obtain proper advice, form a view in exercise of her or his business judgement on what course of action is appropriate, and then pursue it diligently. By taking this course, a defence to insolvent trading would be available and a director could feel able to pursue restructuring options, where appropriate.
As to the second question, a culpable director would trip up at one of the many hurdles – having accurate accounts, getting advice from an appropriately qualified practitioner and pursuing the restructuring plan diligently. It is also to be noted that the business judgement rule itself has objective criteria – eg the judgement must be rational, pursued in good faith and the director must be reasonably informed.
Thus, option two would only open the door to proper director conduct. In this way, Australian law would be brought into harmony with the rest of the world. It would also promote the important policy objective of encouraging directors to obtain early advice when faced with questionable solvency.
It is difficult to predict future business cycles. What is easier to predict, however, is that without urgent reform in the above areas, there will be large public companies that will fail when they ought to have been saved and the jobs of their employees preserved.
Australia is out of step with the rest of the world with its laws in these areas, and Minister Bowen is to be congratulated for issuing a discussion paper aimed at considering and addressing these important issues. It is now up to professionals and participants who work in this area to provide feedback in response to the discussion paper so that law reform in this area can be finalised and implemented.