Safe Harbour

The recent draft insolvency laws aim to offer greater protection to directors, fostering innovation and entrepreneurship, writes James Dunn.

Australia’s insolvency laws have long been considered draconian and out-of-date for an economy that, in the words of Prime Minister Turnbull, is seeking to foster innovation and entrepreneurship.

Critics of the laws contend that they can lead to a premature invocation of insolvency, resulting in job losses, contract terminations, destruction of goodwill and overall value erosion. But a little-noticed part of the National Innovation and Science Agenda launched in December 2015 was a plan to improve the insolvency laws, to encourage more Australians to take business risks.

The government has introduced draft insolvency legislation that has been termed “safe harbour”, given that it seeks to afford directors legal protection from insolvency breaches while they are undertaking a restructure.

In particular, the legislation would exempt directors from personal liability for the company’s debts if it trades while technically insolvent, if the directors can show the debts were incurred while they were taking a course of action that was “reasonably likely” to lead to a better outcome than immediate appointment of an administrator or liquidator.

Concerns over inadvertent breaches of insolvent trading laws are frequently cited as a reason why entrepreneurs are reluctant to start companies, and specialist early-stage investors are reluctant to support them.

Under section 588G of the Corporations Act, directors of a company have a duty to prevent the company from trading while insolvent, and can be held personally liable for debts it incurs in so doing. The problem, however, is that insolvency is often only clear in hindsight.

“When you get into the ‘grey zone’ between where you’re trading solvently or insolvently, there’s usually a period where it’s not clear,” says Lachlan Edwards MAICD, co-head of the Lazard advisory business in Australia and president of the Turnaround Management Association (TMA) of Australia. “Boards are just terrified of that, because of the personal liability.”

Under the “safe harbour” provision, directors will not be held liable for an insolvent company’s debts, if they can show they were in the process of taking a course of action which was “reasonably likely” to lead to a better outcome than immediate appointment of an administrator or liquidator. Importantly:

• Directors will not be able to rely on the safe harbour if employee entitlements are not being paid when they fall due and tax reporting obligations are not being fulfilled.
• There will be no safe harbour if a director fails to substantially comply with certain obligations to assist an administrator, liquidator or controller should the company ultimately proceed to a formal insolvency process.
• A director will not be able to deny a liquidator, administrator or controller access to a company’s books or information and then later seek to use the books or information to evidence a safe harbour.

Whether a course of action is “reasonable” will vary on a case-by-case basis.

Importantly, once a director can satisfactorily prove they are entitled to the safe harbour protection, a liquidator seeking to make the directors personally liable for any debts incurred while the company was insolvent will bear the onus of establishing that the course of action by the directors was not reasonable in the circumstances.

“People had become very fearful of the consequences of continuing to trade, they were potentially so draconian for directors that it actually incentivised people to seek the protection afforded them in bankruptcy, rather than to necessarily drive to the best possible outcome,” says Edwards.

Nor was voluntary administration – introduced in 1993 to encourage directors to place a company experiencing financial difficulties into voluntary administration, with a hope of selling the business or restructuring it and avoid liquidation – much more attractive, he says.

“The difficulty with voluntary administration is that it is effectively perceived as a form of bankruptcy...everybody stops giving you credit terms, they start winding back on support for the business, they become difficult in paying you because they think you might disappear, you might find it difficult to get government approvals, you certainly start to run the risk of losing directors, directors have no say in the business – and control of the business is passed to somebody whose only qualification is that they’re an insolvency practitioner,” says Edwards.

A disruptive process

John Stragalinos, partner at law firm Dibbs Barker, says voluntary administration has helped many companies experiencing difficulties to sell their business or restructure it and avoid liquidation. “But voluntary administration is a very disruptive and expensive process, and it can have a very detrimental impact on a business in terms of value destruction. The reforms have been introduced to encourage restructures and hopefully avoid the need to appoint an administrator,” says Stragalinos.

The problem with voluntary administrations is that “very few ever come back,” says Marcus Derwin MAICD, senior managing director at FTI Consulting, and board member of the TMA.

Rather than companies going straight into voluntary administration, he says the safe harbour provisions – while still putting the onus on the directors and the board to find a solution – allow them more flexibility at an earlier juncture, to get better advice and work through the possibilities.

“The key benefit to the proposed reforms is that they will provide a company, its stakeholders and advisers with time to prepare and implement a restructuring plan, without the threat of the directors being forced to place the company in administration to avoid personal liability,” says Stragalinos.

If directors have a considered restructuring plan that will lead to a better result than administration or liquidation, they should receive some level of protection in order to implement it, says Stragalinos. “In practice, seeking appropriate advice will be a key step in order to obtain the safe harbour protections. I expect, and hope, this will encourage directors to face up to business difficulties and seek advice earlier,” says.

Stragalinos expects the reforms, if legislated, to encourage innovation and start-ups in Australia. “Many start-up businesses do fail, and directors should have some form of protection if their start-up enters financial difficulties but can be successfully restructured for the benefit of all stakeholders, including creditors,” he says.

Arguably even more vital to such an outcome is a second element of the legislation, which will make the “ipso facto” clauses – which allow contracts to be terminated solely due to an insolvency event – unenforceable when a company enters administration, where a managing controller has been appointed, or the company is undertaking a compromise or arrangement for the purpose of avoiding being wound up in insolvency. This will prevent contractors terminating supply and other contracts with the business during the formal restructuring period, if the business is otherwise complying with the terms.

“At present, most of a company’s contracts can be terminated on the occurrence of an insolvency event,” says David Kerr, partner at RSM Australia Partners. “Without the contracts, you have no business and thus nothing to sell or restructure. ‘Ipso facto’ protection is essential to facilitate value maximisation in schemes of arrangement and voluntary administration. But the question of preserving value is questionable, as the market is all-knowing: when there’s blood in the water, the sharks will appear.”

Edwards says the safe harbour reforms are a genuine attempt to resolve this sudden disappearance of support that can afflict companies that get into trading difficulties. “That’s right, there’s no doubt that people can smell blood in the water. The most important aspect of ‘safe harbour’ is that the board starts a process, and brings together the right people to help them navigate a solution, so that there never is the smell of blood in the water.”

More work needed

Kerr argues that the reforms do not go far enough, because the right of a secured creditor with a security interest over the whole – or substantially the whole – of the company’s property to appoint a receiver in the decision period will still exist. That right was removed in the UK in 2002 to encourage the development of a turnaround culture.

“The ‘safe harbour’ is not a magic spell that will suddenly hypnotise the company’s creditors and make them act in the company’s interests and not their own,” says Kerr. “Every creditor will have different interests and a statutory mechanism such as a scheme of arrangement or voluntary administration will be necessary to impose the will of a majority on the minority who could hold out in an informal restructuring. We probably need to take a similar approach to the UK if we are serious about developing a turnaround culture.”

However, Kerr notes that banks have already “dramatically reduced” the circumstances in which they will appoint receivers to distressed companies, because of reputational risk concerns. “Banks have been subject to a high degree of public scrutiny over the past few years. Banks may be presently more inclined to accept a proposal prohibiting the appointment of a receiver and only allowing the appointment of an administrator,” he says.

Derwin concurs that banks and financiers have recently given distressed companies more breathing room. “There have been less enforcement measures over the last two to three years, which is one facet; the other is early identification. Safe harbour should give boards, companies and other stakeholders the opportunity – and the time – to look at what other options are available to them, particularly alternative avenues of capital.”

Where a business once could only “go to the bank or the stock market” for funding, the world is now a “lot more entrepreneurial,” says Edwards. “You have newer providers of capital, who assess risk differently, the sorts of returns they want. You have a much wider range of possibilities now, from hybrids to debt provided by hedge funds, who are willing to price risk and think about outcomes a lot differently to the way that an Australian trading bank would.”

Edwards says one of the most beneficial things about the safe harbour reforms, from a director’s perspective, is time. “When a company is in difficulties, especially with personal liability hanging over their heads, directors can experience very significant stress,” he says. “This legislation is designed to afford directors the time to sensibly explore their options, when they’re not under stress, even distress, and fear, which can cloud their judgement.”

The reforms should be most beneficial to small-to-medium-sized businesses, he says. “They usually don’t have the luxury of time nor capital to look at these options – so historically, they’ve taken the options that are available to them, and have erred on the conservative side, through bankruptcy or formal processes. Now they will have other options and time, and with advice and good stewardship, perhaps be a viable company that comes out the other side. We expect multiple positives for employees, creditors and customers,” he says.

Stragalinos says restructuring a business as a going concern in a planned and controlled manner normally maximises the chances of success of the business continuing. This saves jobs, potentially reduces the government’s Fair Entitlements Guarantee exposure and maintains a viable business that will generate profits and pay income tax, but also protects trade creditors. “It’s sometimes forgotten that in corporate collapses, a large portion of trade creditors are small business people. Corporate collapses have a severe impact on their own financial position,” he says.

No down-under chapter 11

In some quarters, Australia’s proposed “safe harbour” insolvency law reform has been likened to the infamous “Chapter 11” of the US Bankruptcy Code – but the differences outweigh any similarities.

Chapter 11 is a statutory process that requires an application to court to invoke the regime. Once invoked it provides a broad ranging moratorium against creditor actions. The company remains under the control of its directors (that is, it is a debtor-in-possession regime) while the company formulates a restructuring plan, under court supervision. The creditors are broken down into classes as occurs in Australian schemes of arrangement. Each class votes on the proposal, and the court has the power to impose the plan on a dissenting class of creditors.

“Safe harbour gives directors a defence to say, ‘we knew we were in the insolvency grey zone, but we got the best advice, we did this and this and this – and they are all prudent things, and we had a good shot at avoiding insolvency’,” says Lachlan Edwards MAICD, co-head of the Lazard advisory business in Australia and president of the Turnaround Management Association (TMA) of Australia.

“If the company does go into insolvency, the directors will know that they did the best they possibly could, without operating in an environment of fear, which can cloud their judgement. In that sense, safe harbour is like Chapter 11, because it gives directors the opportunity to work without fear. But it is quite different because it is much more operationally focused in terms of providing time to turn things around,” says Edwards.

Safe harbour is “far less prescriptive than Chapter 11,” says Marcus Derwin MAICD, senior managing director at FTI Consulting, and board member of the TMA. “It’s often said that the US is a ‘debtor’ bankruptcy/insolvency system, where Australia’s is steeped in the creditor system. It’s subtle.

“In safe harbour, the lawyers work in tandem with the other advisers as opposed to the lawyers taking control, as they do under the Chapter 11 scenario, in a very prescriptive process,” says Derwin.

David Kerr, partner at RSM Australia Partners, says the proposed safe harbour reforms do not serve the same purpose as Chapter 11, and have no similarities – except one.

“Chapter 11 is subject to the very same criticisms to which Australia’s current insolvency regime is subjected,” says Kerr. “Chapter 11 is described as costly, slow and ineffective in saving companies.”