Progressive Reforms – Recent developments in Australian directors’ liability

Until recently, Australia had some of the strictest insolvent trading laws in the world. Those laws were designed to lift the corporate veil, so that those in control of a corporation could be held liable for debts incurred while the corporation is unable to pay its debts as and when they are due. Section 588G of the Corporations Act 2001 imposes a duty on a director to prevent insolvent trading. It is designed to act as a deterrence on directors incurring debts when the corporation is insolvent. It imposes personal liability and, in severe cases, there are criminal sanctions.

While this act still applies, in 2015 the Australian Productivity Commission recommended reforms to Australia’s corporate insolvency regime, designed to enable restructuring of economically viable companies with less emphasis on punishing for financial failure.

The recommendations of the commission were to restrict formal company restructuring procedures to those businesses that were capable of being economically viable in the future. They also recommended the introduction of a safe harbour defence to allow directors to explore early restructuring options without liability for insolvent trading, and a restriction on the enforcement of Ipso facto rights in certain circumstances.

These changes have now been legislated and have commenced operation. One of the main reasons for their recommendation and implementation was empirical data suggesting that insolvent trading cases were not so extensive, with those cases that do proceed to trial, often weighted heavily in favour of the liquidator plaintiff as against the defendant director.

Following corporate failure, directors are often penniless and pursuing them is not economic. It is therefore not unsurprising to find that reported cases of insolvent trading are not extensive in the more than 40 years since Australia has had insolvent trading laws, in one form or another.

The commission sought to address the tension between the desirability for strong insolvent trading protection on the one hand and encouraging a business restructure while the corporation is in financial distress on the other.

Safe harbour reforms
One of the ways they have achieved this is via the implementation of safe harbour reforms. The object of the reforms is to encourage directors to pursue restructuring opportunities that will deliver a better outcome to key stakeholders.

A safe harbour applies from the time the directors, who suspect insolvency, start to develop and implement a course of action that is reasonably likely to lead to a better outcome for the corporation than immediate administration or liquidation. It also operates as an exception to the insolvent trading provisions of the Corporations Act 2001, providing directors protection from any personal liability for debts that are incurred directly or indirectly in connection with the course of action.

Directors can still be liable for insolvent trading if they continue to incur debts while the corporation is insolvent, but safe harbour, if implemented correctly, can provide a defence to insolvent trading, thereby encouraging restructure and turnaround solutions as opposed to liquidation and personal liability.

Safe harbour rules require directors to take an active role in the restructure, while acting honestly and genuinely. They must also use up-to-date financial information to assess the likely outcome of restructure and comply with obligations to pay employee entitlements when they fall due. Meeting all of the company’s taxation reporting obligations, while properly maintaining books and records is also a requirement.

Under safe harbour rules, directors must engage with key stakeholders to develop and implement the restructuring plan. Once it becomes clear that a corporation is not viable, the protection of safe harbour will cease. Protections are not absolute and will require extensive advice and planning as well as consultation with key stakeholders. Their object is to encourage a restructure if it is reasonably likely to lead to a better outcome for the corporation.

Safe harbour does not appear to protect against other breaches of the Corporations Act 2001 and a liquidator may well still be entitled to pursue a creditor for an unfair preference, i.e. where the creditor is paid when the corporation is insolvent and the creditor receives more than they would if the corporation was wound up.

Ipso facto reforms
These reforms introduce a stay on parties being able to enforce rights against a corporation which goes into administration, has a receiver appointed or enters into a scheme of arrangement. The aim of these reforms is to preserve the going concern value of a corporation by creating a moratorium on enforcement of certain clauses in commercial contracts.

Without these reforms, a restructure may be jeopardised because the going concern value of a corporation can be destroyed by enforcement action. The new provisions introduce a stay on enforcing contractual rights including termination rights where the corporation goes into administration, has a receiver appointed or enters into a scheme of arrangement.

The stay is expressed to be a restriction on the ability to enforce a right that arises by reason of an express provision of a contract, agreement or understanding. The court maintains an overriding discretion to lift a stay, if that is appropriate in the interests of justice.

The Safe Harbour and Ipso facto reforms are significant changes to the corporate insolvency and restructuring landscape in Australia. They promote or seek to promote maximising the opportunity for preserving a going concern to assist with a corporate restructure in appropriate circumstances. The reforms present a useful step towards dispelling the long-held view that insolvent trading in Australia is focused on punitive outcomes rather than promoting entrepreneurship.

This article is an excerpt from the IR Global Australasian Guide. A full copy of the publication can be accessed here