“Safe harbour” amendments to the Corporations Act 2001 (Cth) (CA): Problems and Predictions

1.0    Background to the legislation and the safe harbour provisions

1.1  On 12 September 2017 the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 (Cth) was passed by both Houses of Parliament and became the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth) (new Act) when it received Royal Assent on 19 September 2017.

1.2  The new Act comes on the back of the unfortunate, nightmare-inspiring Insolvency Law Reform Act 2017 (Cth) which commenced, fully, on 1 September 2017, much to the horror of insolvency practitioners (IPs) throughout Australia.

1.3  The new Act introduces two major reform: (a) the so-called ipso facto amendments; and (b) the so-called “safe harbour” reforms.

1.4  The ipso facto provisions will come into effect on the later of (a) 1 July 2018, or (b) the day after 6 months after Royal Assent. However the Governor-General may make a proclamation that it is to commence earlier. That is not expected however and the likely start date will be 1 July 2018.

1.5  The ipso facto reforms are designed to prohibit the automatic termination (or the ability of a non-defaulting party to elect to terminate) a contract by reason only of:

1.5.1          The company seeking to avoid being wound up in insolvency by use of the a scheme of arrangement under Part 5.1 CA;

1.5.2         The appointment of a managing controller; or

1.5.3         The appointment of an administrator.

1.6  Doubtless this is a noble objective and may have given One.Tel a chance of survival back in 2001. That insolvency is probably the most commonly cited illustration of how the value of a business can be destroyed overnight because of the ipso facto clause.

1.7  However, the proposed new provisions will not prevent the operation of ipso facto clause for any other reason e.g. non-payment or non-performance under a contract. There is no moratorium imposed in any of these other circumstances on an ipso facto operating with full force and effect. Thus, with freedom of contract being a key principle of commercial life, it is unlikely that the ipso facto proposals will have much effect at all except in another One.Tel situation which happened 16 years ago.

1.8  The safe harbour provisions came into effect on 19 September 2017. It is these provisions which are discussed here.

1.9  The provisions relate only to any debts incurred on or after that date.

1.10  The safe harbour provisions are designed to provide protection for company directors against Australia’s “rigorous” insolvent trading laws under section 588G of the CA when the directors seek, in a bona fide way, to restructure their company.

1.11  It is well recognised that Australia has some of the harshest insolvent trading laws in the world. A director can become personally liable for allowing a company to incur a debt if, among other elements, at the time the debt is incurred, there are reasonable grounds to suspect that the company is insolvent or will become insolvent by the incurring of the debt.

1.12   In England, the test is much more lenient. There the Court has a discretion under section 214 of the Insolvency ACT 1986 (UK) to order that a director may be liable to “make such contribution (if any) to the company’s assets as the Court thinks proper” if:

1.12.1 The Court is satisfied that at the time the debt was incurred the director knew or should have known that the company had no reasonable prospects of avoiding insolvency; and

1.12.2 In that case, the director did not take all possible steps to minimise the loss to creditors.

1.13  In the UK, the relevant test for insolvency is the balance sheet test. This is distinct from the Australian position where the cash flow test is applicable. A company in the UK becomes insolvent “at a time when its assets are insufficient for the payment of its debts.” This means that the time when a UK company becomes insolvent generally would occur later than for companies trading under Australian law.

1.14  The US, in even starker contrast to the Australian position, does not have any insolvent trading laws at all. There are penalties for fraudulent conduct but no insolvent trading laws as such.

1.15  The safe harbour protection is drafted as a defence to an insolvent trading claim under section 588G CA and is contained in section 588GA of CA.

1.16  The evidential onus of establishing the defence is on the director claiming the benefit of it.[1]

1.17  The purpose of the safe harbour provisions is to encourage directors of companies to attempt to restructure and keep alive companies which previously would be placed (often prematurely, it is said) into administration because of fear by the directors that they would be pursued for insolvent trading.

1.18  It is said that the safe harbour laws have been enacted to:

“promote entrepreneurialism and encourage business people with the right skills , experience to serve as company directors.”[2]

1.19  Section 588GA of the new Act essentially contains three principal issues which a director will need to address in order to gain safe harbour protection:

1.19.1  First, the director must show that at the time the director starts to suspect that the company is insolvent or may become insolvent, the director “starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company.”[3]

1.19.2   There is a list of factors which are set out, as a guide only, in determining this “better outcome” test.[4] These include whether the director:

1.19.2.1   Is taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company;

1.19.2.2   Is obtaining appropriate advice from “an appropriately qualified entity who was given sufficient information to give appropriate advice;”

1.19.2.3   Is developing or implementing a plan for restructuring the company to improve its financial position;

1.19.2.4   Is properly informing himself or herself of the company’s financial position.

1.19.3      Secondly, the director will need to establish that the debts which were incurred were debts incurred in connection with the “better outcome” course. It would seem that any new financing which is a typical part of restructuring would certainly fall within the “debt incurred” towards a “better outcome” test.

1.19.4      However what of the ordinary trade creditor who struggles getting paid at the best of times. How can one say that further obtaining of credit from a particular trade creditor represents “a debt incurred” towards  getting a “better outcome”? This is particularly so when the debt actually increases during the safe harbour period. Is one supposed to say; “oh well, the creditors won’t get much now if the company is placed into administration, so let’s have a go at a “better outcome” by trading on and see what happens”.

1.19.5      Thirdly, safe harbour protection does not apply if when the debt is incurred:

1.19.5.1     The company is failing “to pay the entitlements of its employees by the time they fall due,”[5] or

1.19.5.2     The company is not giving returns, notices, statements, applications or other documents as required by taxation laws,[6] or

1.19.5.3     The company fails substantially to comply with their obligations to assist an administrator, liquidator or controller in a formal insolvency under CA sections 475(1), 497(4) or 530A(1).[7]

1.19.5.4     The director has “cease[d] to take… [a] course of action [reasonably likely to lead to a better outcome for the company]”.[8]

1.19.5.5     The course of action “ceases to be reasonably likely to lead to a better outcome for the company”.[9]

1.19.5.6      When an administrator or liquidator is appointed”.[10] [11]

1.20  Interpretation issues are apparent when considering such undeveloped and currently ill-defined concepts such as:

1.20.1    The concept that the director seeking protection “starts developing one or more courses of action? It seems that something more than mere “thinking about” the possible course or courses of action is required after the director has been allowed a “reasonable period” to think.[12]

1.20.2   The expression “reasonable period” is not defined but the explanatory memorandum gives some examples. One example is Sue (full name withheld!) who runs a restaurant. She realises that the business may be insolvent and thinks about engaging expert professional assistance. However Sue gets busy and does nothing to alleviate her financial problems and a month later her bank appoints a managing controller. Not surprisingly, it is suggested that Sue would be unable to rely on safe harbour. Another example is Nic (without a “k”) who runs a whiskey bar. He thinks he is trading “gangbusters” and has plenty of stock on hand. However, Nic then discovers that there is very little whiskey in the barrels and immediately calls in the experts who formulate a plan of action. Nic is protected by safe harbour.

1.20.3    These are very obvious examples and these and a few other examples which are provided do not address however the more difficult, “marginal” factual circumstances which are likely to arise in the real world.

1.20.4    The expression “reasonably likely” does not connote a better than 50% probability of a “better outcome” than the appointment of a liquidator or an administrator’ but rather a chance of achieving a better outcome that is not fanciful or remote, but is “fair”, “sufficient” or “worth noting”.[13] This attempted definition is confusing. “Fair”, “sufficient” and “worth noting” could apply to a wide range of circumstances, none of which have any connection with something being “reasonably likely”. A red traffic is certainly “worth noting”; and it is probably not “fair” if on the roulette wheel the chances of landing on an odd number is less than 50%.

1.20.5   Perhaps it may have been better not to even attempt to define “reasonably likely” at all.

1.20.6   The “better outcome’ is in respect of “the company”. Who or what though is “the company”? Why is it not in respect of “the creditors of the company”? Intuitively, that would seem to make more sense as the whole concept of the safe harbour revolves around an attempt to rescue companies in financial distress, rather than immediately place them into administration or liquidation. Perhaps the drafters assumed that what was good for the company must be good for the creditors. But that is a non sequitur. In cases where the restructuring effort fails dismally, what may be good for the directors with safe harbour protection certainly may not be good for the creditors.

1.20.7    Certainly, the provisions may result in a better return to the employee creditors as the defence is not available if the company fails to “pay the entitlements of its employees by the time they fall due”. But what exactly does this mean? Does it mean the same as the expression in section 95A CA (definition of solvency/insolveny) “as and when they become due and payable”? If not, why not? Why have the drafters altered the expression slightly? Mysteriously, the Explanatory Memorandum is silent here and the drafters go home for a chuckle, knowing that some poor Judge will at some stage likely need to question the reason for the slight variation in the language.

1.20.8    And assume here that a long-standing employee who has just become eligible for long service leave elects to defer the taking of the leave for one reason or another for 6 months. Is the company compelled nevertheless to pay the leave entitlement immediately it became due? It would seem so as the word “pay” is used. That should be contrasted with some earlier versions of the final Bill which required the entitlements to be “provided for” (or similar), and then of course there was a lengthy debate as to what that meant.

1.20.9   The fact the legislation is drafted in such a way that to get into the safe harbour and to remain in it, the company must have paid all its employee entitlements (including superannuation) up-to-date, and have all its tax lodgements up–to-date,  is hardly consonant with the typical insolvent or financially struggling company.

1.20.10   Who is “an appropriately qualified entity” who is to be engaged by the director? ARITA submitted that such a person should be either a registered liquidator or a member of ARITA, however this submission was not accepted. There are potential advantages and disadvantages with the current position. The advantages are that respectable turnaround specialists such as the TMA members who often are not registered as liquidators or members of ARITA will not be excluded, however the possible disadvantage is that those unscrupulous persons currently involved in “phoenix” activities may seek to become involved. 

1.20.11   No particular qualifications are required for the position of “an appropriately qualified entity” however, sensibly, one would look towards a person with some business/accounting experience in the relevant industry and probably someone with a relevant tertiary degree.

1.20.12  As is evident from the above, much of the language of the new legislation is vague. For example, when exactly does a “person [cease] to take… a course of action” to achieve a better outcome?[14] And when exactly does a course of action cease to be “reasonably likely to lead to a better outcome for the company”?[15] This is an area likely to be awash with large tax invoices for the generation of expensive expert reports by febrile insolvency accountants versed in “divining” the point at which a company becomes insolvent.

2.0  Other provisions

2.1    If a person fails to deliver up to a formal appointee, books and records of the company required to be delivered up under a provision of the CA, then that person cannot use those books and records if that person is later sued for insolvent trading. Those books and records cannot be used in an attempt to obtain safe harbour protection. So, a director cannot withhold books and records (which they sometimes do so as to frustrate a liquidator from pursuing an insolvent trading action), and later produce those records as an attempt to prove the director was in safe harbour. If records are in fact withheld, then really all that means is that we will be exactly where we are today in many cases i.e. with the liquidator with few records and all defences, apart from safe harbour, still available to the director : a very messy situation.

2.2  Liability of a holding company for the insolvent trading of a subsidiaries is also covered by the safe harbour provisions[16] in the same way as a single company as described above. The holding company will be protected if its subsidiary is in safe harbour and the holding company takes reasonable steps to ensure the subsidiary is complying with its obligations to remain in the safe harbour.

2.3  There is provision for a Ministerial review of the operation of the new provisions after 2 years. The review will cover the following:

2.3.1         The impact of the availability of the safe harbour on the (a) the conduct of directors; (b) the interests of creditors and employees; and

2.3.2         Any other matter the Minister considers relevant.

2.4  That review is to be undertaken by 3 persons who the Minister considers possess appropriate qualifications to undertake the review.

3.0  Some general observations

3.1  As mentioned above the new provisions have been drafted as a defence to an action by a liquidator for insolvent trading. The pre-existing defences are all still available. In particular, the 4 statutory defences set out in section 588H remain unchanged. It will be recalled that they are:

3.1.1         The “reasonable grounds to expect” and did expect that the company was solvent at the time the debt was incurred or would remain solvent even if the debt were incurred defence;

3.1.2         The “competent and reliable” person being relied upon defence;

3.1.3         The “non-participation” due to illness or other good reason defence; and

3.1.4         The “taking of all reasonable steps to prevent the incurring of the debt” defence.

3.2  As with these grounds the onus with the safe harbour defence lies on the director.

3.3  With failed restructuring efforts under safe harbour, a liquidator, as currently, will lay out in the claim the elements as set out in section 588G. It will then be up to the director to raise the defences.

3.4  Refer to the text to footnote 11 above which refers to circumstances when safe harbour ceases to apply. It is likely that the defence will most commonly plead that the circumstance which will first took the company outside of safe harbour will be administration or liquidation. That is because the other 2 circumstances are likely to have occurred prior to that and there will be room for the liquidator to assert, in his or her formal (court document) reply, that one or other of the 2 circumstances arose well before administration or liquidation. That then becomes messy and litigious.

3.5  A very odd and probably deliberate feature of safe harbour is that there is no obligation upon the company to actually tell anyone that it has entered or is about to enter safe harbour.[17] That is in stark contrast to the voluntary administration process where there are mandatory meetings and reports to creditors and also in stark contrast to Chapter 11 in the US where the court petition must contain a list of creditors and a summary of assets and liabilities.

3.6  Query whether there should be some obligation upon the company to inform creditors that it is entering/has entered safe harbour. This is particularly relevant when one recalls that the trigger for entry into the safe harbour is that a director starts to suspect that the company may become or is, at that point, actually insolvent. In a sense it seems most unfair to the general body of unsecured creditors not to tell them of the financial position of the company, so that they can take advice as to how to best protect their interests.

3.7  Perhaps the secrecy was considered by the drafters as necessary to avoid the potential destruction of any restructuring efforts as such an announcement may well cause panic amongst the company’s unsecured creditors and cause them to cease supply and/or demand a variation of trade terms, issue statutory demands to exert pressure on the company to get paid, threaten winding up or possibly insist on COD arrangements rather than continuing with credit terms which are not being complied with.

3.8  It is perhaps not speculating in the extreme to suggest that this may well be a normal human reaction by creditors who are told that the company to which they are suppling goods and services is insolvent or may become insolvent.

3.9  Question also whether a director should be given the protection in the former circumstance just mentioned i.e. when he or she starts to suspect that the company is in fact insolvent. It is difficult, if not impossible to reconcile that circumstance with the “no reasonable grounds to expect” defence available to a director in section 588H(2). In other words the addition of the safe harbour defence would appear to eliminate the traditional defence under section 588H(2) if the directors do inform the creditors of the safe harbour entry.

3.10  In addition, in respect of voidable preferences, if the company informs its unsecured creditors that it is in financial difficulties and has entered or is about to enter safe harbour, then the creditors’ ability to rely on the “no reasonable grounds” defence under section 588FG may be severely curtailed.

3.11   The elevation of the employee rights to essentially ensure a return of 100 cents in the dollar is curious. Does this mean that employees will likely have been preferred if the restructure fails and the company is wound up? Arguably, yes. Would the liquidator pursue the employees? Arguably not. Why? Not only would that be undesirable “optics” for the liquidator but there is an element of futility in it because of the priority afforded to employees under section 556 CA.

3.12  In addition, the IPs and insolvency lawyers will need to take care in respect of their payment arrangements for work done during the restructure, to avoid the prospect of a liquidator clawing back payments made to them during the attempted restructure period. The most obvious protective mechanism here is to obtain money in trust “on account of costs and outlays to be incurred” so as to avoid the operation of the preference recovery provision in section 588FA on the basis that at the time of the relevant payment no debtor/creditor relationship existed.

3.13  As the safe harbour provisions do not cover debts incurred prior to entry into the safe harbour, it is advisable for the company when paying suppliers to specify that the payment is being made in respect of the oldest debts first.

3.14  Just how the courts will approach this new legislation and whether it will have the        effect hoped for by the Government remains to be seen. Possibly until some case law starts to emerge, it would be prudent to warn clients that at this early stage it is not possible to give detailed or specific advice as to whether some “course of action” will or will not protect the director from insolvent trading.

3.15  Some predictions:

3.15.1     The obligation to ensure that employee entitlements and taxation lodgements are up to date upon entry into the safe harbour and are at all times kept up to date, will disqualify many otherwise eligible companies from using safe harbour.

3.15.2     If the general body of unsecured creditors are informed of the entry into safe harbour, or if they find that out, trading terms are almost certain to be altered by the creditors attempting to protect their position.

3.15.3     In addition it is unlikely that normal trading will simply continue if the general body of unsecured creditors find out that the company is seeking safe harbour and it is quite possible, or perhaps even likely, that statutory demands will issue and threats of winding up made in order to exert pressure upon the company for payment.

3.15.4     The comments made under the last 2 points indicate that there will be significant obstacles to any restructuring effort. That is not the least because, unlike administration which imposes a statutory moratorium to give the company some “breathing space”, safe harbour does not. Rather, the basic assumption underlying safe harbour appears to be that if or when creditors are told that the company is entering or is in safe harbour, they will not modify their behaviour by changing trading terms or attempting to otherwise protect themselves.

3.15.5     Realistically creditors will change their behaviour in the ways described above and once that occurs the prospects of a successful restructure will diminish.

3.15.6      As has traditionally been the case in Australia, there will be many instances where the directors have not accepted their plight or that of their company and by the time they realise that the position is hopeless and beyond rescue, it probably is.

3.15.7     Guarantees will be enforced against the directors who will often then not have the financial resources to engage an experienced turnaround accountant (and lawyer where necessary or appropriate) who will, to avoid being pursued by a liquidator for a preference, want their fees and outlays fully covered “upfront”.

3.15.8     Directors who are well and truly past the point of just “start[ing] to suspect” financial difficulties will nevertheless attempt to use safe harbour as a defence.

3.15.9     There will be some cases over the next months and years which will clarify the meaning of some of the obscure expressions in the new Act. It will only be when the courts start commenting upon the new Act that one will start to gain an appreciation of how the court will approach the legislation.

3.15.10  That case law will emerge out of insolvent trading actions where the restructure was of course unsuccessful, and there is a contest between the liquidator and the director as to whether and to what temporal extent the director was entitled to rely upon the safe harbour defence.

3.15.11  The new Act will have little impact on “incentivising” entrepreneurialism and “encouraging business people with the right skills, experience to serve as company directors” in Australia. It is far better bet serving as a director in the UK or the USA where true entrepreneurialism is not discouraged by the spectre of having to defend oneself from attack by a liquidator for insolvent trading and carrying the onus of proof with such a defence.

[1] Section 588GA(3).

[2] EM 1.33.

[3] Section 588GA(1)(a).

[4] The expression “better outcome” is defined to mean an outcome that is better for the company than the immediate appointment of an administrator, or liquidator, of the company: section 588GA(7). This of course is suggestive of the better outcome being for the benefit of creditors and not directors.

[5] Section 588GA(4)(a)(i).

[6] Section 588GA(4)(a)(ii). The failure to pay employee entitlements of keep taxation returns up-to date requires “substantial compliance” and no more than “2 or more failures …during the 12 month period ending when the debt is incurred.”

[7] These provisions relate to the obligation upon directors to assist appointees in formal insolvencies under the CA, by, for example, completing RATAs and delivering up books and records.

[8] Section 588GA(b)(ii).

[9] Section 588GA(b)(iii).

[10] Section 588GA(b)(iv).

[11] Of the last 3 points, the safe harbour will cease to apply when the earliest of these occurs: section 588GA(1)(b). It seems likely that the first 2 of the last 3 points will occur before the last of the 3.

[12] Section 588GA(1)(b)(i).

[13] Explanatory memorandum, 14 [1.52].

[14] Section 588GA(b)(ii).

[15] Section 588GA(1)(b)(iii).

[16] Section 588GB.

[17] The exception here is publicly listed companies which are subject to the ‘continuous disclosure’ rules of the ASX.

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