Thinking | 17 March 2020
How the safe harbour regime can help businesses through the economic effect of COVID-19
A new 'safe harbour' regime was implemented in September 2017 to provide directors who were trying to save a business with protection from future insolvent trading claims. No one could have predicted how important that regime is about to become. Given the escalating stress that is being placed on businesses because of COVID-19, many otherwise successful businesses may risk meeting the definition of insolvency. If the business ultimately cannot survive, directors may be personally at risk of future insolvency trading claims unless safe harbour is implemented.
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 does not prevent this claim by resigning before a liquidator is appointed; the claim extends to past directors for any insolvent trading debts incurred while they were a director.
The insolvent trading provisions were enacted to stop companies from continuing to trade even though they were insolvent, and in trading, incurring debts to creditors who were unlikely to receive full payment. The provisions were also intended to encourage directors to act promptly when the company was facing financial distress, by either solving that distress or by appointing an administrator (to try to save the company) or liquidator (if the company cannot be saved).
Relief through safe harbour
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 safe harbour regime is intended to achieve a balance between protecting creditors and enabling directors to try to save the company. It provides an exception from liability under the insolvent trading provisions provided certain criteria are met.
As a result of safe harbour, directors will not be trading while insolvent (ie they 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.
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 the COVID-19 minimisation measures, many otherwise successful businesses may become at risk of meeting this definition of insolvency. If those businesses 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.
The Corporations Act provides pre-requisites to being able to establish that the 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:
(a) properly informing themselves of the company's financial position;
(b) 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;
(c) taking appropriate steps to ensure that the company is keeping appropriate financial records;
(d) obtaining advice from an appropriately qualified entity, who was given sufficient information to give appropriate advice; and/or
(e) 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 our experience, proper advice and ongoing monitoring is essential to the success of safe harbour in protecting directors.
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