Kick-Starting Safe Harbour Insolvency Reforms

The focus of insolvency law reform needs to return to substantive issues like safe harbour legislation to encourage directors to attempt informal work-outs so that more troubled companies can be saved.

Significant reforms to regulate Australia’s insolvency profession are expected to be finalised this year. They seek to improve creditor, and more broadly, community confidence in insolvency practitioners and their procedures by aligning corporate and personal insolvency laws and clarifying the powers of courts and regulating bodies in monitoring and disciplining inappropriate conduct.

The proposed reforms were released by the Federal Government in December 2011. That action followed a Senate inquiry in 2009 and the release of its paper in September 2010 (The Regulation, registration and remuneration of insolvency practitioners in Australia: the case for a new framework), various high profile cases in which the courts considered the misconduct of certain liquidators and the release the Federal Government’s Options Paper in June 2011 (A modernisation and harmonisation of the regulatory framework applying to insolvency practitioners in Australia).

Submissions to the proposed reforms were required in early February 2012 and draft legislation is now expected.

As suggested by The Eye in the Insolvency Law Bulletin in January 2012, finalisation of the reforms would allow the Federal Government “to return to the main focus of any insolvency regime”, being its substantive laws.

At the same time as announcing reforms to regulate Australia’s insolvency profession, proposed insolvent trading safe harbour reforms were contained in a discussion paper (Insolvent Trading: A Safe Harbour for Reorganisation Attempts Outside of External Administration) released in January 2010 by the then Minister for Financial Services, Superannuation and Corporate Law, Chris Bowen MP. However, this fell off the agenda in September 2011 when David Bradbury MP, Parliamentary Secretary to the Treasurer, announced that the Federal Government would no longer be considering industry submissions. This immediately shut down the possibility of providing a safe harbour to directors who attempt informal workouts to save viable companies in financial distress.

The insolvent trading safe harbour discussion paper came in response to calls from insolvency practitioners and industry representative bodies in the wake of several large corporate collapses and the global financial crisis.

Under Australia’s corporations laws, an insolvent company must immediately cease incurring debts and is inevitably placed into administration. Directors who fail to follow these provisions face personal liability for all debts incurred, including imprisonment if their breach was dishonest. Directors and shadow directors are liable under corporations laws even if they do not have actual knowledge of the company’s insolvency.

Australia’s insolvent trading prohibition has been described by industry experts and commentators as being draconian and the strictest in the western world. It compares with legislation in the UK, which provides a wrongful trading test that is triggered only when directors knew, or ought to have concluded, that there was no reasonable prospect that the company would avoid going into liquidation. In New Zealand, a reckless trading prohibition considers the actions of directors based on whether the company had any prospect of continuing to trade profitably in accordance with ordinary commercial practice and requires a substantial risk of serious loss to the company’s creditors. The US does not have a statutory insolvent trading provision but relies on the tort of deepening insolvency. This tort arises where a company has continued to trade despite its directors knowing that it would not benefit.

Australian law is distinct from, and more prohibitive than, the protections in these three jurisdictions. Firstly, this is because it imposes liability immediately upon insolvency without regard to the directors’ intentions which, at that time, might have been an attempt to save the business. Secondly, it renders directors liable for all debts incurred during that period. In these other jurisdictions, courts have discretion to make an order for a director to contribute a sum of money to the liquidation by way of compensation.

Australia’s insolvent trading prohibition is not only strict and restrictive, but it creates uncertainty for directors in the concept of insolvency itself because whether a company is solvent or not, and whether it will continue to be solvent, is often difficult to determine. Companies may experience many periods of temporary balance sheet insolvency, despite being able to pay their due debts well into the future. Defining the precise point of insolvency can involve extensive retrospective analysis by legal and financial experts. During a time of uncertain financial stability, it is even more difficult for directors to be confident about current and future solvency when considering the expected value of company assets and the future provision of funding to support them from local or international sources.

The difficulty in defining the precise point of insolvency, the associated risks of personal liability and a financially precarious market, makes it extremely risky for directors to engage with major creditors, bankers or investors to attempt informal workouts. Often directors are left with little choice but to appoint a voluntary administrator. At the outset, this creates a conflict between the concern about the directors’ own liabilities and the interests of the company, its creditors and shareholders.

The voluntary administration regime was intended by the legislators to provide a mechanism for corporate rescue by providing a breathing space from creditor claims and to allow insolvency practitioners to consider and assess ongoing viability. But this formal insolvency appointment more often than not signals the inevitable death of a company. Often the appointment is made too early or unnecessarily, in direct response to Australia’s insolvent trading prohibitions.

The appointment of a voluntary administrator usually triggers ipso facto clauses in contracts preventing the company from being able to deal with its, often critical, suppliers and leading secured creditors to appoint their own insolvency practitioners and receivers to protect their interests. Again, it is worth noting that other jurisdictions, such as the US, do not permit automatic termination clauses in contracts upon the appointment of an insolvency practitioner.

In Australia, the stigma of the appointment of a voluntary administrator will often lead to the loss of customers, goodwill and the fire sale of assets in an already over-burdened property and asset market which destroys enterprise value and denies the company its chance to effectively restructure and return to profitability. The consequent liquidation has a significant and undeniable impact on creditors, employees, shareholders, suppliers, customers, the business, and in the case of large enterprises, the industry, local community and Australia’s global economic position.

In order to address and prevent these significant impacts, the now abandoned Federal Government discussion paper proposed the following three options for reform:

  • to maintain the status quo;
  • to adopt a modified business judgment rule in respect of a director’s duty to avoid insolvent trading; or
  • adopt a mechanism for invoking a moratorium from the insolvent trading prohibition while workouts are attempted.

Peak industry bodies such as the Law Council of Australia, the Insolvency Practitioners Association of Australia (IPA) and the Turnaround Management Association Australia, supported the modified business judgment rule defence, with suggestions for a slight modification to provide a safe harbour for directors to salvage financially distressed companies. The IPA also recommended that Australia consider amendments to invalidate or suspend the operation of ipso facto clauses in defined circumstances.

Currently, Australia’s corporations laws provide directors with a defence that they breached their duties of care and diligence in limited circumstances. The defence can apply if a business judgment was made on a matter in which they did not have a material personal interest, which they rationally believed was in the best interest of the company, on an adequately informed basis and in good faith for a proper purpose. The Government’s insolvent trading modified business judgment rule proposed to extend this protection. It would have required that directors be satisfied that the company’s financial accounts and records presented a true and fair picture of its financial circumstances, that they had secured expert restructuring advice on the merits of a workout and that they were making a business judgment in the interests of the company’s creditors and members.

At the time the discussion paper was released, Mr Bowen announced that following the closure of submissions to the discussion paper he intended to introduce a draft bill in the September 2010 parliamentary sitting. The Federal election intervened and a further year passed before Mr Bradbury announced that the Federal Government did not intend to consider further the proposed reforms. The Australian Financial Review reported that Mr Bradbury’s reason was that no evidence had been provided that the reforms would increase the rate of company survival.

Definitive evidence on the rate of company survival should not be the only test. The government should also seek to address the immediate concern of how company liquidations can be prevented because they have a significant flow-on effect to employment, the economy and recessionary business conditions. Company administrations continue to rise, with 9,829 in 2011, up 5.9 per cent from the previous year.

The effective restructure of individual companies will depend on their trade, customers, financial affairs and industry and economic conditions at the time. Failing to permit an environment for directors to attempt an informal workout without risking their own financial viability stifles the opportunity for successful restructures of productive businesses. Given the unquestionably detrimental impact of liquidations during times of financial uncertainty, surely it is worth ensuring that Australia has effective safe harbour mechanisms to encourage directors to act, with appropriate guidance, to save viable companies.

In 2010, the Government’s campaign to consider insolvent trading reforms was well progressed. They received more than 20 submissions from industry bodies and professionals in response to the discussion paper. The subject has been debated and it is now up to the Attorney-General, Nicola Roxon, and/or the Parliamentary Secretary to the Treasury, Bernie Ripoll, to reignite consideration of the reform proposals and take serious heed to the successes of the well-advised corporate workouts in the more permissive and supportive UK, US and
New Zealand jurisdictions.

The revived consideration of regulation of the insolvency profession indicates the Government’s renewed emphasis on reforming Australia’s insolvency laws. Let’s hope that it does not take an increasing number of company failures or another significant corporate collapse, to have the reform proposals put back on the Government’s agenda.