Thinking | 9 September 2020

Good reasons for directors to comply with safe harbour during insolvency trading moratorium

Despite the extension of the insolvent trading moratorium, directors should still satisfy the usual requirements of the safe harbour against insolvent trading if they can.

Earlier this week, the Federal Government announced that the temporary six month moratorium from insolvent trading liability will be extended until 31 December 2020. Temporary changes to statutory demands requiring a debt of $20,000 and allowing six months to pay the amount demanded have also been extended to this date. These measures had otherwise been due to expire later this month.

Do directors need to worry about insolvent trading for the remainder of 2020?

Australian directors have long been under a legal duty to prevent their companies from incurring debts when the company is insolvent and there are reasonable grounds for suspecting that the company is insolvent.^[1]

In response to the severe impact of COVID-19 government-imposed restrictions on business, the Federal Government amended the Corporations laws^[2] so that for the six months commencing 25 March 2020 a director will not be liable for insolvent trading in respect of a debt incurred in the ordinary course of the company’s business. The Federal Government has now confirmed it will extend this ‘insolvent trading moratorium’ until 31 December 2020.

Since 19 September 2017 directors have been able to avoid the insolvent trading laws applying to debts incurred during a period that they qualify for the safe harbour against insolvent trading^[3]. Qualifying for safe harbour requires certain hurdles to be met, such as employee entitlements being paid and tax documents lodged when due and the company must be developing or implementing a course of action which is reasonably likely to lead to a better outcome than immediate voluntary administration or liquidation.

Many directors who otherwise would have sought the protection of the safe harbour have decided not to do so, instead relying on the insolvent trading moratorium. However, despite the insolvent trading moratorium, there are very good reasons for directors still to comply with the requirements for safe harbour.

Debts incurred ‘in the ordinary course of business’

It will be up to directors to prove the debt was incurred in the ordinary course of business to avoid the insolvent trading laws applying^[4].

There is a risk that a court might decide that a debt isn’t incurred in the ordinary course of business. While the phrase 'in the ordinary course of business' is found in various Acts, there is no consistent judicial view on the meaning of the phrase.

The Explanatory Memorandum^[5] which accompanied the introduction of the insolvent trading moratorium says 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 insolvent trading moratorium and says this could include, for example, a director taking out a loan to move some business operations online or debts incurred through continuing to pay employees during the coronavirus pandemic.

This suggests that the insolvent trading moratorium is intended to apply not only to debts incurred as part of the ordinary day-to-day trading operations, but possibly also to debts incurred to restructure a business to enable it to survive in a restructured state. Unfortunately, explanatory memoranda are rarely taken into account by the courts when interpreting statutes and so a court may interpret the terms differently to what the Government intended.

When a company is insolvent or of doubtful solvency, a director’s duty to act in the best interests of the company requires the director to take into account the interests of creditors and the impact on them when making decisions. In the context of whether the company should incur a debt, a director should have a reasonable belief the company will be able to pay the debt if incurred. If, when a debt is incurred, there is limited, to no, prospect of the company being able to return to solvent trading and to pay the debt at some point, the director should not allow the company to incur it. A debt incurred in these circumstances is unlikely to be incurred in the ordinary course of business.

For these reasons, if there is any doubt about whether debts to be incurred will be in the ordinary course of business, it makes sense for directors to comply with the requirements of safe harbour if they can satisfy them.

Anti-Phoenixing laws protection

New Anti-Phoenixing laws^[6] that came into operation in February 2020 prohibit company officers and other persons from engaging in conduct which results in a company entering into creditor-defeating dispositions.

A ‘creditor-defeating disposition’ is a disposition of property for less than market value or less than the best price reasonably obtainable given the circumstances which has the effect of preventing, hindering or delaying the property becoming available to creditors in a winding up of the company.

The Anti-Phoenixing laws extended the safe harbour laws to protect directors and other persons from personal liability for dispositions which would otherwise be creditor-defeating dispositions if they are entered into during the safe harbour and made, directly or indirectly, in connection with a course of conduct that is reasonably likely to lead to a better outcome than a voluntary administration or liquidation.

Therefore, another reason for directors to try to ensure the safe harbour applies to them (and again, even during the temporary moratorium against insolvent trading) is that they can cause the company to dispose of property in connection with a restructuring plan without the spectre of them being personally liable for causing the company to enter into a creditor-defeating disposition.

The Anti-Phoenixing laws also prevent a court from making a disposition by a company voidable as a creditor-defeating disposition if entered into when safe harbour applied to the company’s directors.

Given this carve out for dispositions made during safe harbour, purchasers of assets from distressed businesses may seek warranties that the directors of the vendor, to the best of their knowledge, are complying with the requirements of the safe harbour.

Safe harbour requires good governance and ‘best’ financial practices

Various hurdles must be met in order to qualify for safe harbour protection. The company:

must pay employee entitlements and lodge tax documents when due; and
must be developing or implementing a course of action (eg a restructuring plan) which is reasonably likely to lead to a better outcome than immediate voluntary administration or liquidation.

When considering whether the course of action adopted was reasonably likely to lead to a better outcome for the company, the court can have regard to whether the director:

was developing or implementing a plan for restructuring the company to improve its financial position;
obtained advice from an appropriately qualified person who was given sufficient information to give appropriate advice;
properly informed themselves of the company’s financial position;
took appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay all its debts; or
took appropriate steps to ensure that the company kept appropriate financial records consistent with the size and nature of the company.

During safe harbour it is common for the directors, key senior management and their advisors to meet frequently to review the financial position and progress against the restructuring plan so the directors can confidently consider whether better outcome test continues to be met.

Directors who have been through a safe harbour often comment that these structures and rigours are very beneficial for their business and lead to peace of mind. Many decide to maintain some or all of these practices even after the solvency crisis has passed.

Financiers like (and may require) safe harbour

Financiers don’t like their customers to be financially distressed, but where they are and they need to seek forbearances or indulgences from their financier, financiers gain comfort from the directors of their customers being in safe harbour. Financiers know that safe harbour requires the directors of their customers to have obtained expert advice, to have developed a restructuring plan, to be on top of the financials and to be up to date with employee payments and tax lodgements. Financiers are increasingly seeking confirmation that their financially distressed customers are in safe harbour and some are starting to require it a condition of granting forbearances.

The insolvent trading moratorium will end

Unless further extended, the insolvent trading moratorium will end on 31 December 2020. At the very least, it makes sense for companies who are unsure about whether they will be solvent on or after 1 January 2021 to start getting their house in order now so that they can comply with safe harbour as soon as the moratorium ends.

Our team of experts can assist you to access the safe harbour against insolvent trading.

[1] Section 588G of the Corporations Act 2001 (Cth).

[2] The Coronavirus Economic Response Package Omnibus Act 2020 inserted a new section 588GAAA into the Corporations Act titled 'Safe harbour—temporary relief in response to the coronavirus'.

[3] Section 588GA of the Corporations Act.

[4] Section 588GAAA(2) of the Corporations Act.

[5] Paragraph 12.18 of the Explanatory Memorandum for the Coronavirus Economic Response Package Omnibus Act 2020.

[6] Treasury Laws Amendment (Combating Illegal Phoenixing) Act 2020.