The coronavirus pandemic will put many companies in distress as the world experiences an economic downturn. Directors need to be aware of their duty to prevent insolvent trading, as well as “safe harbour” protections which could give them breathing room through the crisis.
With legislation giving relief to directors from personal liability for insolvent trading, some information in this article is now out-of-date. Find out more about the latest developments here.
In these unprecedented times, many companies may find themselves suddenly – and unexpectedly – in financial distress. Revenues will drop, cash flow may dry up and far-reaching social and economic impacts may follow.
Companies must look to do the right thing by their workers, customers and other stakeholders while at the same time ensuring their financial sustainability. Boards have a critical role in steering their companies through this crisis.
For many boards, solvency may become a concern. In the current climate, all directors should be mindful of the “safe harbour” protections available to them, which are designed to give directors comfort that they can take common sense steps to rehabilitate distressed businesses without being exposed to personal liability for insolvent trading.
Duty to prevent insolvent trading
Under Australian law, a director has a duty to prevent insolvent trading.
In effect, the Corporations Act requires a director of a company to prevent the company from incurring a debt if:
- the company is already insolvent at the time the debt is incurred; or
- by incurring that debt, or by incurring a range of debts including that debt, the company becomes insolvent, and, at the time of incurring the debt, there are reasonable grounds for suspecting that the company is already insolvent, or would become insolvent by incurring the debt.
Insolvent trading leaves a director open to civil penalties or criminal charges (where dishonesty is a factor), as well as personal liability to compensate for losses.
Safe harbour protections available
In 2017, the law was changed to introduce a “safe harbour” for directors seeking to take common-sense steps to rehabilitate distressed businesses.
The availability of the safe harbour means that a director will not be liable for insolvent trading if:
- at a particular time after a person starts to suspect a company may become or already be insolvent, he or she starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company; and
- the debt is incurred directly or indirectly in connection with that course of action and during a specified time period.
Importantly, the provisions enable a company to restructure outside of a formal insolvency process and provide directors with an opportunity to remain in control of the company and attempt to solve financial difficulties.
A link to an AICD Director Tool on the safe harbour can be found here.
The AICD was a strong advocate over many years for the introduction of the safe harbour provisions, which have proved valuable in the insolvency context. By providing protection from personal liability, when adhered to properly, the reforms have allowed directors to preserve value for shareholders, employees, creditors and other stakeholders.
The current crisis will prove an important test for the safe harbour provisions, as more companies seek to rely on them.
Is reform needed?
In these extraordinary and uncertain times, Government will need to consider a wide-range of policy action. The impact that insolvency laws could have on business and the broader economy, as the effect of the coronavirus is realised, will need to be a focus, and all options that might help keep businesses afloat should be on the table.
The safe harbour laws are relatively new but will undoubtedly be put to the test in the current environment. As such, Government and other stakeholders will need to keep a close eye on how they are being utilised, and their effectiveness.
The AICD is actively considering any option to give directors greater confidence to steer their companies through these challenging times without fear of personal liability, and will closely consider any reforms that may be put forward by stakeholders or government.
Four operating cash flow insolvency warning signals
Insolvency warning signals can be detected by examining the net cash flows from operating activities.
Four key warning signals are:
- net operating cash outflows (ie, negative operating cash flows);
- payments to suppliers and employees are higher than receipts from customers;
- net operating cash flows are lower than profit after income tax; and
- a lack of self-generation.
Other warning signals include: evidence of breakdown in internal controls, delayed payments to creditors, evidence of worsening financial situation (eg high and increasing gearing, deteriorating profitability or continuing trading losses) and delays in financial reporting to the board.
Questions for Directors seeking to rely on the safe harbour
The AICD Director Tool on the safe harbour outlines a number of suggested steps to consider when using the safe harbour.
At a minimum, directors will need to ask themselves these questions:
Am I properly informing myself of the company’s financial position?
Have appropriate steps been taken to prevent misconduct by officers or employees that could adversely affect the company’s ability to pay its debts?
Have appropriate steps been taken to ensure the company is taking appropriate financial records consistent with the size and nature of the company?
Has advice been obtained from an “appropriately qualified entity” who has been given sufficient information to give appropriate advice?
Are we developing or implementing a plan for restructuring the company to improve its financial position?
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