Achieving port in an insolvency storm – stays in a safe harbour?

The government has released draft legislation reforming insolvency laws to create a ‘safe harbour’ defence for directors faced with an insolvent trading claim, together with a statutory stay on the enforcement of ipso facto clauses when a party to a contract enters a formal administration process. This is good news for company directors and delivers on industry calls for law reform.

Background

On 28 March 2017, the Minister for Revenue and Financial Services, The Hon Kelly O’Dwyer MP, released draft legislation and an accompanying draft Explanatory Statement (ES) setting out proposed further reforms to Australia’s insolvency laws.

The reforms, as part of the Federal Government’s National Innovation and Science Agenda, aim to ‘promote a culture of entrepreneurship and innovation and help reduce the stigma associated with business failure’.

The latest release follows the enactment of the Insolvency Law Reform Act 2016 (Cth) (IRLA) in February 2016, which commenced last month. The provisions of the IRLA that are now in force relate broadly to the registration and discipline of registered liquidators, notification of contraventions of deeds of company arrangements (DOCAs) and lodgement of Declarations of Relevant Relationships and Indemnities (DIRRIs) in voluntary administrations. The remaining provisions of the IRLA are set to commence on 1 September 2017.

The current draft legislation proposes two areas of law reform:

‘Safe Harbour’ defence

Under section 588G of the Corporations Act 2001 (Cth), company directors have a duty to prevent insolvent trading. A director may be held personally liable for debts of a company if those debts were incurred when the company was insolvent. A director may be excused from liability if it can be established that they took appropriate and reasonable action to prevent the company from incurring the debt. Often the courts will look at the director’s attempt to appoint a Voluntary Administrator (VA) when a director is faced with an insolvent trading claim.

The ES suggests that the fear of liability under insolvent trading laws often pushes company directors to appoint a VA, in circumstances where the company may be viable in the long term. It is said that VAs are almost always ‘value destructive’ and make it hard for the company to restructure, increasing the likelihood of the company being placed into liquidation.

Accordingly, the proposed legislation creates a ‘safe harbour’ for directors from liability under the insolvent trading provisions. The change is intended to ‘encourage honest company directors to remain in control of a financially distressed company and to take reasonable steps to restructure and allow it to trade out of its difficulties’ as well as facilitating company restructures outside a formal insolvency process.

How it will operate

The proposed safe harbour operates to protect a director from liability for debts incurred from when a director takes action that is reasonably likely to lead to a better outcome for the company and the company’s creditors. Protection ceases when (i) the action ends, (ii) the course of action stops being reasonably likely to result in a better outcome for the company and its creditors, or (iii) the company enters external administration.

The ‘better outcome’ test is an objective test, dependent on the circumstances of each case. An indicative and non-exhaustive action list is set out in the draft legislation and includes:

1. the steps taken to prevent misconduct by officers and employees of the company
2. the steps taken to ensure the company maintains appropriate financial records
3. obtaining appropriate advice
4. the director keeping themselves informed about the company’s financial position and
5. developing and/or implementing a restructuring plan to improve the company’s financial position.

In order to obtain protection, the company must continue to meet its employee entitlements and taxation reporting obligations. If the company is subsequently placed into external administration, the directors must comply with requests from administrators for copies of the books and records of the company. Failing to do so will result in a director being unable to rely on that evidence to support any defence under the safe harbour provision.

The reform also reverses the burden of proof - once a director provides some evidence that meets the ‘low initial evidential burden’ as to the reasonableness of the action taken, it is then up to the liquidator (or other party) to establish that action taken by the director(s) was not reasonably likely to result in a better outcome for the company and its creditors.

Ipso facto clauses

An ipso facto clause is a clause in a contract allowing one party to terminate or otherwise modify the operation of the contract upon the occurrence of a specified event. These clauses are often used in commercial contracts and take effect upon an insolvency event of the counterparty (for example, the appointment of administrators).

These clauses may reduce the scope for a successful restructure, destroy enterprise value of a business entering into formal administration and prevent the sale of a business as a going concern. Destroying goodwill and lessening returns to creditors goes against the policy behind Australia’s insolvency regime.

Under the proposed legislation, clauses which allow a contract to be terminated or varied solely due to the occurrence of an insolvency event, regardless of continued payment or performance, would be stayed during a formal restructure. Practically, this prevents a party from terminating a contract due to the mere happening of an insolvency event.

There are numerous exceptions to the general stay set out in the draft legislation. These include a broad range of financial product contracts where ipso facto clauses are ‘commercially necessary’.

More information and next steps

The new reforms are substantial and significantly alter the current law. As a starting point, businesses should begin to review their standard form supply contracts to consider what additional safeguards are needed to protect against the insolvency of a counter party, in the event the ‘ipso facto’ reforms are enacted.

As with the consultation paper released last year which introduced the reforms, the current draft legislation is expected to receive extensive interest from business and legal and insolvency practitioners.

A copy of the draft legislation and accompanying draft explanatory memorandum can be accessed here.

Submissions on the draft legislation are open until 24 April 2017.

In addition to the proposed reforms outlined in this article, the Attorney General will shortly be releasing legislation which will reduce the standard bankruptcy period from three years to one year.

Hall & Wilcox will be closely monitoring developments.