Two safe harbours: what business owners need to know about insolvent trading during the COVID-19 pandemic

An edited version of this article first appeared in Smart Company.

By Special Counsel Katherine Payne and partners Mark Petrucco and Wayne Kelcey

One of the earliest economic stability measures passed by the federal government to battle COVID-19 involved a new form of safe harbour, which provides directors with short-term relief from the insolvent trading provisions.

Temporary safe harbour joins the pre-existing safe harbour regime, which was introduced in 2017, and was just beginning to see regular use before the health crisis commenced. Both safe harbour options provide directors with an exemption from liability for insolvent trading, which can provide comfort for directors who need time to consider the company’s position before developing a turnaround plan or pursuing formal insolvency options.

However, the scope and operation of the two regimes differ on some fundamental points. Directors should consider their options under both regimes, and in doing so, remember their broader directors’ duties remain in place.

Insolvent trading

When a company goes into liquidation, the liquidator can make a claim against the directors personally for any debts incurred by the company at a time that it was insolvent. A director cannot prevent a claim by resigning before a liquidator is appointed; a claim extends to past directors for any insolvent trading debts incurred while they were a director.

The insolvent trading provisions aim to prevent companies from continuing to trade while insolvent, and in trading, incurring debts to creditors who are unlikely to receive full payment. The provisions also encourage directors to act promptly when a company is facing financial distress, by either remedying the situation or by appointing an administrator (to try to save the company) or liquidator (if the company cannot be saved).

A company will be insolvent if it cannot meet its debts as and when they fall due. Given the escalating stress which is being placed on businesses as a result of COVID-19, many otherwise successful businesses may become at risk of meeting this definition of insolvency.  If a business ultimately cannot survive, the directors may be personally at risk of future insolvent trading claims, unless safe harbour is implemented.

A proper safe harbour implementation process is essential. This must be done during the time of financial difficulty; once a liquidator is appointed is too late.

Temporary safe harbour for COVID-19  

The temporary safe harbour regime commenced on March 25, 2020, and applies for six months until September 25, 2020.  It provides an exemption from the risk of personal liability for insolvent trading, provided certain conditions are met.  It aims to provide a safety net to help financially distressed businesses continue operating during a temporary period of illiquidity, to avoid unnecessary insolvencies during this crisis period.

Under the new section 588GAAA inserted into the Corporations Act 2001, a director will not be personally liable for insolvent trading in respect of a debt incurred by a company if that debt is incurred:

1. In the ordinary course of the company’s business; and
2. During the six-month period from 25 March to 25 September 2020, or any longer period prescribed by the regulations; and
3. Before any appointment of an administrator or liquidator of the company during the temporary safe harbour application period.

The protection will also be available for a holding company’s liability for the insolvent trading of its subsidiary, provided the holding company takes reasonable steps to ensure that temporary safe harbour applies to each of the directors of the subsidiary and to the relevant debts.

The evidential burden will fall upon directors to show that debts were incurred ‘in the course of business’ and within the relevant timeframe (section 588GAAA(2)).

In the context of other insolvency issues, the courts have confirmed that the phrase ‘ordinary course of business’ will have different meanings in different circumstances.  For temporary safe harbour, the government has sought to provide guidance through its explanatory memorandum.

This states ‘a director is taken to incur a debt in the ordinary course of business if it is necessary to facilitate the continuation of the business during the six month period’.  The following examples are provided: ‘A director taking out a loan to move some business operations online’ and ‘debts incurred through continuing to pay employees during the coronavirus pandemic’.  This suggests that temporary safe harbour may apply not only to debts incurred as part of ordinary routine trade, but also to debts incurred to keep the business operating through the pandemic.

Importantly, the protection under this regime is time-restricted.  It will only provide relief for debts incurred before September 25, 2020 (unless extended by the government).

The temporary safe harbour will provide comfort if the company:

• Will be able to recover quickly and be in a position to pay its debts in the next six months; and
• Only needs to incur debts in the next six months which are clearly within the scope of the company’s ordinary course of business.

However, the cost of COVID-19 is such that many businesses will face economic difficulties well beyond the six-month period currently allocated.  It is important the directors are honest about the scope of the issues facing the company and the breadth of the protections required. This may warrant employing the pre-existing safe harbour provisions, in addition to relying on temporary safe harbour.

Pre-existing safe harbour 

The safe harbour provisions in section 588GA of the Corporations Act were implemented in September 2017 to provide directors who were trying to save a business with protection from future insolvent trading claims.

In 2016, Treasury recognised that the potential risk of an insolvent trading claim limited the ability of companies to trade through financial difficulty. Further, at times it resulted in the potentially unnecessary loss of a business that could otherwise have been successfully restructured and continue to operate.

The pre-existing safe harbour regime was intended to achieve a balance between protecting creditors and enabling directors to try to save the company. Like temporary safe harbour, it provides an exception from liability under the insolvent trading provisions, provided certain criteria are met.

Under this regime, directors will not be personally liable for debts incurred by the company if they can establish that the debts were incurred at a time when they were pursuing a course of action that was reasonably likely to lead to a better outcome for the company than liquidation.  This is the case even if the company was insolvent (or likely to become so) at the time the debt was incurred.

The section 588GA of the  Corporations Act provides pre-requisites to being able to establish that the following safe harbour exception applies.

1. The directors need to be developing one or more courses of action which is reasonably likely to lead to a better outcome for the company. To determine whether a course of action is ‘reasonably likely to lead to a better outcome for the company’, the court may have regard to whether the director is:
   i) Properly informing themselves of the company’s financial position;
   ii) Taking appropriate steps to prevent misconduct by officers or employees of the company, which could adversely affect the company’s ability to pay its debts;
   iii) Taking appropriate steps to ensure that the company is keeping appropriate financial records;
   iv) Obtaining advice from an appropriately qualified entity, who was given sufficient information to give appropriate advice; and/or
   v) Developing or implementing a plan for restructuring the company to improve its financial position.
2. Any further debts are incurred directly or indirectly in connection with that course of action, during the period that the course of action is being implemented and continues to be reasonably likely to lead to a better outcome for the company.
3. The company is meeting its obligations to pay employee entitlements and comply with its taxation reporting obligations.

Importantly, the protection will no longer apply if the directors cease to fulfil these elements, or if the course of action is no longer reasonably likely to lead to a better outcome for the company.

In many instances, these requirements simply constitute good financial management during financial distress. It is sensible for directors at this time to ensure they are properly informed of the company’s financial position, take appropriate steps to prevent employee misconduct that could jeopardise solvency, keep good financial records, obtain appropriate advice, and develop and implement a plan to maximise the company’s chances of surviving the current marked issues. Many of the federal government’s economic stability payments are also linked to the company filing its Business Activity Statements, such that companies will be required to comply with their tax reporting obligations regardless of whether safe harbour is employed.

These safe harbour provisions require only that the course of action developed by the company is ‘reasonably likely’ to lead to a better outcome for creditors than the immediate appointment of an external administrator. It does not require that this better outcome be guaranteed.

However, unlike temporary safe harbour, best practice in applying the pre-existing safe harbour regime generally requires that an accountant with insolvency experience provide a ‘better outcome analysis’. This provides an objective assessment of whether the course of action is reasonably likely to lead to that better outcome. The report is commonly relied upon to satisfy the key pre-requisites of safe harbour, but does necessitate some additional cost.

The return for this cost is comfort for directors that all debts incurred in association with the plan will be covered by the regime, and that this protection is able to extend beyond six months.

Don’t forget directors’ duties

Neither regime exempts directors from their director’s duties. Under the Corporations Act and at equity, these require directors to:

1. Exercise their powers and discharge their duties with the degree of skill and diligence that a reasonable person would exercise if they were a director of a corporation in the company’s circumstances, and held the same role and responsibilities as the director (section 180 and fiduciary duty);
2. Exercise their powers and discharge their duties in good faith in the best interests of the company and for a proper purpose (section 181 and fiduciary duty);
3. Not improperly use their position to gain an advantage for themselves or someone else or cause detriment to the corporation (section 182 and fiduciary duty);
4. Not improperly use information obtained because they are (or have been) a director to gain an advantage for themselves or someone else or cause detriment to the corporation (section 183 and fiduciary duty); and
5. Prevent conflicts of interest arising between their private interest and the company’s interest, and act only in the best interests of the company (fiduciary duty).

The case law is clear that where a company is insolvent, or even approaching insolvency, the obligation to act in the best interests of the company requires directors to consider the best interests of the creditors.  To this end, the High Court expressly held that, in the context of an insolvent company, ‘any failure by the directors to take into account the interests of creditors will have adverse consequences for the company as well as for them’.

The trigger for this duty is where the directors knew of the risk of solvency, or ought to have known of the risk of solvency.

Given insolvency is defined as when a company is unable to meet its payments as and when they fall due, many Australian businesses currently risk insolvency.  Directors should, therefore, ensure they act on the basis that they have a duty to the company’s creditors.

Although safe harbour can apply, a future liquidator could argue that incurring debts when a director was reasonably aware, or ought to be aware, that those debts could not be paid by the company is a breach of these duties, and particularly, a breach of the duty to creditors. Whether directors have satisfied their duties depends on the specific facts of each situation, and may depend on the scope, quantum and type of debts incurred, and the company’s circumstances and prospects at the time those debts were incurred.

When navigating through this uncertainty, directors should always act in the best interests of the company.  When approaching insolvency, this should include the company’s creditors. Obtaining advice as to the company’s options will be essential to meeting these duties.

In summary

There is a role for both safe harbour regimes in the current economic climate.

The temporary safe harbour measure will allow for increased flexibility for companies working through financial distress over the next six months.  The pre-existing safe harbour regime may provide additional comfort to directors likely to require assistance over a longer period.

In either event, directors must remain conscious of their broader director’s duties, and in particular, their duties to act in the best interests of creditors.

Whichever approach is adopted, in our experience, proper advice, documentation and ongoing monitoring are essential to a company’s ability to address times of crises.