Insolvency explained

Friday, 01 September 2017


    Ben Power looks at the role and limitations of directors when a company goes into administration.

    On 14 June 2017, Channel 10’s directors placed Australia’s third-ranked television network in the hands of administrator KordaMentha. The network’s plight, involving high-profile directors and shareholders including Lachlan Murdoch and James Packer, has put insolvency firmly on the front page.

    For directors, the threat of insolvency and possible administration is a complex, emotional and difficult time as they grapple with conflicting concerns around trying to save the company, but also protecting themselves from Australia’s draconian insolvent trading laws.

    Australia’s culture of stigmatising corporate failure and favouring creditors over debtors has created little incentive for directors to work towards restructuring and turning around companies. Once their company is placed in administration, directors are effectively sidelined.

    But administrators say directors can still play a positive role throughout every phase of the administration process and work to position companies for recovery.

    Melissa Humann, partner at PPB Advisory, says, “It’s all about people being proactive and getting the right advice, whether legal, accounting, or restructuring advice. That’s what we want to see.”

    The good news is that directors will soon have a stronger role in creating a new turnaround and restructuring culture in Australia, with new laws set to provide greater legal protection and allow them to develop timely turnarounds with much greater confidence.

    The troubling twilight zone

    When a company’s financial troubles first emerge, directors face an immediate decision as to whether to place a company in administration. Under Australian corporations law, directors must appoint an administrator when they decide a company is insolvent or likely to become insolvent.

    Mark Korda, Channel 10’s administrator and one of Australia’s top restructuring experts, says the period when directors and management realise the company is in difficulty, but they are unsure whether to place the company into administration, is dubbed ‘the twilight zone’.

    The twilight zone “is an uncomfortable time for the company and directors,” says Scott Atkins MAICD, partner and insolvency and restructuring lawyer at Henry Davis York.

    Administrators all have one key message for directors during the twilight zone: act early and get advice. “It’s during that period where they do the most to set the company up for a successful restructure rather than a catastrophic failure,” says Peter Gothard, Sydney practice leader at financial advisory and restructuring firm Ferrier Hodgson.

    Acting early means bringing in advisers as soon as trouble appears. “Don’t wait till the last minute when all options are exhausted,” Gothard says. “It’s very frustrating getting called in at the last minute and the situation is dire and there’s not much we can do. We like to be engaged early.”

    But directors face significant risk during the twilight zone. If directors allow the company to trade while insolvent they may not only be liable for debts, but also face criminal charges. “The law really pushes directors down a path of administration when they’re concerned that the company is in financial distress,” says Lysarne Pelling GAICD, senior policy adviser at the Australian Institute of Company Directors (AICD).

    In recent decades, the number of companies going into administration has increased significantly. In 2015–16 some 9,848 Australian companies were placed in external administration, according to ASIC. While that’s down from 10,757 five years earlier, it represents a significant rise on the 4,205 companies placed in external administration in 1999–2000.

    To reduce the number of administrations, encourage innovation and increase turnarounds and restructures, the federal government has introduced new laws into parliament that give directors a legal ‘safe harbour’ if they develop a course of action that is reasonably likely to lead to a better outcome for the company than going straight into administration or liquidation [see the breakout on p41].

    “Safe harbour is all about trying to get directors to consider the company’s position early in the piece,” Humann says. “That’s a positive development. It’s all about giving directors time without that pressure or threat of insolvent trading hanging over their heads.”

    She says directors will be more incentivised to seek advice early, come up with a plan early, and get a clear picture of the business, rather than putting it into administration “as a defence mechanism.”

    Korda says that during the twilight zone, along with exploring restructuring and turnaround options, directors should also be developing a contingency plan for possible administration. Channel 10 directors, for example, called him in early to prepare a contingency plan if they decided to appoint an administrator.

    He notes ASIC recently said in the Federal Court it was proper and prudent for directors to engage professionals to do a turnaround, but also to draw up a contingency plan. There are three steps directors can take during the twilight zone.

    1. Make sure you’re available and helping management more than you would in a more stable environment. That means hands-on input, level headedness and really working with management through the crisis.
    2. Get a very good handle on the financial position of the company, particularly its cash flow.
    3. Get appropriate legal and financial advice because directors need to comply with the law.

    A difficult loss of power

    Despite efforts to restructure, some companies will inevitably be placed in administration. The stark truth is that when a company is placed in administration, directors effectively stand aside. All the power to run the company and deal with its affairs goes to the administrator.

    “Directors don’t have any power anymore,” Gothard says. “They’re not dismissed, they don’t automatically resign, they’re still there on the records but they have no powers at all.” Gothard says that directors need to recognise that control has passed. “That can be difficult for directors, as you can imagine.”

    Directors do, of course, have statutory obligations. They need to provide the company’s books and records to the administrator, provide a written report within five business days, and meet with, or report to, the administrator to help them with enquiries. If directors don’t co-operate with the administrator, the matter can be referred to corporate regulator, the Australian Securities and Investments Commission.

    While directors have a limited role during administration, they can still play a positive role to maximise the chances of the company recovering.

    They can firstly ensure a smooth transition to the administrator.

    Humann says, “it’s important directors do stick around for a number of reasons, mainly to show good faith to employees, suppliers, customers, and so forth.”

    Korda says that while he mainly deals with CEOs and CFOs who are also directors, and typically has little involvement with non-executive directors, directors can be helpful if they have corporate knowledge, important relationships with customers or good contacts.

    Henry Davis York’s Atkins notes there are many examples of administrators, especially in complex businesses, determining and identifying early on who they need assistance from in the management and director group. While the CFO or CEO may also be directors, the administrator might also turn to a director with significant operational capacity for help.

    Administrators say they have few issues with professional directors during administration. “Broadly, because we work at the top end of town we have never had any real significant difficulties with directors,” Korda says.

    “We might have had to make some redundant because we’re doing the turnaround, but we’ve never had any significant issues with directors of public companies in terms of cooperation, etc. If we have, we can go to ASIC and get them to help.”

    But it can be more challenging for directors of smaller and family-owned companies. Smaller companies dominate administration: in 2013–14, some 81 per cent of companies in administration had fewer than 20 employees.

    Gothard says it can be unhelpful if directors stick around too much. “They have to accept that they have no power,” he says. “It’s been transitioned to the administrator and the administrator makes all the decisions. They can’t do anything without the administrator’s approval.”

    It’s also unhelpful communicating with outside parties in a manner inconsistent with the administrator’s message.

    Directors with deeds

    After a company has been placed in the hands of administrators, its fate will ultimately be decided at a meeting of creditors. The two most likely outcomes are liquidation or a Deed of Company Arrangement (DOCA).

    Directors, of course, can propose a DOCA. “Anyone can propose a restructuring plan for the company,” Gothard says. “If the directors are interested in restructuring a company and reassuming control of it, they could think about a plan for dealing with a company’s debts in such a way that the company is saved.”

    Gothard says he sees such proposals reasonably often, although it’s most likely in smaller family companies. “In larger companies, it is more typical for financiers and investors to work directly with the administrator on a restructuring plan” he says.

    Humann says when pursuing a DOCA the same principle to earlier stages applies – move early. She cites family jewellery business, Bevilles, whose director and CEO (family members) took active steps in the pre-appointment stage to review the group’s performance and consider how the business could be restructured to allow it to prosper into the future.

    “Those proactive steps meant that the family, as proponents of a DOCA proposal, could ‘hit the ground running’ once the decision was made to appoint voluntary administrators,” she says.

    The voluntary administration process took less than five weeks from appointment to conclusion. “A speedy resolution was critical in order to preserve the goodwill of the business,” Humann adds.

    A new culture of turnaround

    Korda says Australia’s companies have changed, which means the focus of administration is evolving. “They used to be full of hard assets: land, buildings, plants and equipment. You used to realise those. More companies now have intangibles, like Channel 10’s programming and people.

    “They suit work-out better than liquidation,” he says. “The trend is very much to restructuring companies rather than formal insolvency.”

    Safe Harbour

    Directors are set to get greater legal protection during the uncertain period, known as the ‘twilight zone’, when financial difficulties become apparent but before a company is placed in administration.

    Under current laws directors face personal liability for debts and even criminal charges if a company trades while insolvent. Critics have argued that the laws encourage directors to jump quickly and place a company in the hands of an external administrator, and remove incentives for directors to pursue restructuring and turnaround outside the formal insolvency process.

    Scott Atkins, partner at law firm Henry Davis York, says the laws have a wider impact on Australian business culture and the economy because they discourage healthy risk-taking culture and stifle innovation. He says the existing system is creditor-driven rather than debtor-driven.

    The federal government is introducing new laws that provide a ‘safe harbour’ from civil liability for directors who attempt a restructure in certain circumstances.

    Lysarne Pelling GAICD, senior policy adviser at the Australian Institute of Company Directors (AICD), says the new laws, if passed, should give directors “greater confidence” to pursue a restructure or turnaround rather than appoint an external administrator.

    Under the new laws, if directors suspect a company might be insolvent or might become insolvent, but start to develop a course of action that is reasonably likely to lead to a better outcome for the company than going straight into administration or liquidation, they’re afforded the protection of a safe harbour.

    But Pelling says the safe harbour is “not by any stretch a free pass for directors”. “The safe harbour ends if the course of action is no longer likely to lead to a better outcome,” she says. “Directors need to keep making that assessment.”

    The directors will also be unable to rely on the safe harbour if it fails to pay its employees (including superannuation) and meet its tax reporting obligations. And if restructuring doesn’t work and the company enters into a formal insolvency process, the safe harbour will only be open to directors who provide an administrator or liquidator with certain information and assistance.

    The amendments would also make ‘ipso facto’ clauses unenforceable if a company has entered into a formal insolvency process. Currently, ‘ipso facto’ clauses allow contracts to be terminated or unilaterally amended solely due to an insolvency event. Pelling says the reform will prevent such clauses cutting the scope for a successful restructure, or stopping the sale of a business as a going concern, during a formal insolvency.

    Pelling says the AICD strongly supports the new legislation: “It’s really important for our economy.”

    But she says the proposed laws could be improved to reduce complexity and uncertainty around the need for directors to engage in ‘counterfactual analysis’ – evaluation of the various outcomes that may flow from one or more courses of action – and compare them with the immediate appointment of an administrator or liquidator.

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