Michael Hughes, a partner at Minter Ellison, outlines how directors of Australian subsidiary companies can be confronted with stark challenges when an overseas parent company becomes insolvent.

    Protecting your reputation and assets

    A global corporation typically will operate in Australia through a wholly owned subsidiary company. Under the Corporations Act, either one or two directors must be Australian residents (Section 201A) and they will be appointed alone, or with others who might be employees of the parent company. It is critical to recognise that even though this subsidiary company might operate as the Australian branch of a worldwide conglomerate, it is still obliged to perform its obligations under Australian law. If there is a collapse of the global corporation, Australian subsidiary directors will face unique and personal risks. In addition to damaging their reputations, local directors might lose their ability to manage other Australian companies.

    A number of high profile corporate collapses – such as Walter Constructions, Gate Gourmet and Akai – offer many lessons for local directors who sit on the boards of subsidiaries of global corporations.

    Lesson 1
    Be robust and independent

    It is trite to say that directors must exercise their duties in the best interests of the company, and normally this means with the interests of shareholders in mind. But once the company becomes insolvent or near insolvent, it is the interests of creditors which are paramount, and any director misconduct cannot be ratified by the shareholders (Kinsela v Russell Kinsela Pty Limited (1986) 10 ACLR 395).

    Particular care must be taken with any instruction to ‘sweep’ the Australian company’s bank account, either on an ad hoc basis, or as part of an established procedure for cash management on a global basis. If funds are transferred overseas while the company was insolvent or near insolvent, this transaction will be carefully examined by a liquidator appointed to the Australian company. The reasons for funds transfer and the benefit said to have been derived by the Australian company will come under the liquidator’s microscope. This is especially so where Australian creditors are left unpaid, and the resulting loan to the parent cannot be recovered because it too is insolvent, or has been applied to repay an existing parent company loan. Allowing this to happen will expose local directors to personal liability.

    Lesson 2
    Regularly review and update letters of comfort

    In many cases, the Australian subsidiary can only continue to trade with the support of the parent company. There may be a large inter-company loan account to the Australian company, which is only repaid as free cash emerges. The ‘going concern’ assumption which enables auditors to sign off on the accounts is often underpinned by a letter of comfort from the overseas parent.

    These letters can provide more than just ‘comfort’ to an Australian director. Even if it is alleged that the director should have suspected that the company was insolvent, and so should be made personally liable for its debts (section 588G ), the letter of comfort may provide a defence because it is the basis for a reasonable expectation that the company is actually solvent (section 588H(2)). Also, it may be legally enforceable, and so provide a basis for the liquidator of the Australian company to obtain compensation from the parent company, or at least lodge a claim in its liquidation (Gate Gourmet Australia Pty Ltd (in liquidation) v Gate Gourmet Holding AG [2004] NSWSC 149).

    These letters of comfort are very important documents. Therefore, directors should obtain copies of, and personally review, the terms of the letters of comfort. Do not rely on the auditors to say they exist. What party is giving the letter? What do you know about its financial position? What does it say? It needs to be capable of having a defined or certain effect. Take particular care if it is capped as to time or amount. It should either be unlimited –?eg the parent company will pay all of the Australian company’s debts as and when they fall due – or of an amount sufficient to ensure all debts (including contingent debts, to land lords, lease creditors and the ATO) are paid in full. Why is the letter of comfort given? There must be an intention to create legal obligations.

    These questions need to be answered before taking important steps, such as signing the annual accounts. It is also wise to require that letters of comfort are confirmed by the parent company if you are being asked to sign off on a significant transaction. Where the transaction is for a greater amount, or extends over a longer period than is specified in the letter of comfort, it should be re-issued so as to apply to all liabilities likely to arise from that transaction. If in doubt obtain independent legal advice on these matters.

    Lesson 3
    Review and maintain your D&O insurance

    Once a parent company becomes insolvent, any indemnity it has provided to Australian directors will be of doubtful value, and the D&O insurance policy might be the directors’ only hope of a soft landing.

    Obtain copies of, and personally review the terms of, the D&O policy. Check the exclusions – does it cover insolvent trading – will it cover your costs even though you are not sued, for example, does it cover the costs of dealing with the liquidator, a public examination or an ASIC investigation?

    Keep a copy of the D&O policy. Do not rely on the company secretary who says it’s in place –?trying to work it out after insolvency is difficult, and the delay can be fatal. What is the amount of the cover? When does it expire? Diarise to contact the company secretary and ask to be kept up to date as the time comes to renew the policy, and stay close to that process. Watch for any signs that the underwriter is not prepared to renew the policy, as this can be an early warning sign of insolvency.

    After any formal insolvency, do whatever you can to keep the policy alive. Most D&O polices operate on a claims made basis, ie the policy must be current at the time a claim is made regardless of when the circumstances giving rise to the claim occurred. The problem is that the policy may expire in the first few months of the start of any formal insolvency administration and is unlikely to be renewed, and yet the claim can come months, or years after that.

    Also endeavour to notify the underwriter of any ‘circumstances’, as might give rise to a claim, including any comments or assertions that might have been made, even on a preliminary basis which might suggest that a claim will be made. Notification of these ‘circumstances’ should be enough to trigger cover for a claim that emerges from them.

    Lesson 4
    Act promptly in the event of parent company insolvency

    It is a brave company director who resolves to press on in the face of parent company insolvency, especially knowing that the parent is not able to perform its obligations under any letter of comfort. Following law reform announced earlier this year, it is hoped that in the future there might be something approaching a single, or at least coordinated, insolvency administration of an international enterprise. However, even after this comes into effect it is unlikely that the fact that, for example, a parent company has commenced Chapter 11 proceedings in the United States will of itself provide the directors of its Australian subsidiary the protection they require against claims under Australian law. Even in that context directors will need to act as they should do now, to move promptly to appoint a voluntary administrator, or invoke some other formal process under Australian law.

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