Safe Harbour Guide

What Company Directors who suspect insolvency should do to avoid personal liability for Insolvent Trading.
PART I Safe Harbour & Directors' Liability for Insolvent Trading

On 19 September 2017 amendments, to the Corporations Act 2001 commenced which create a “safe harbour” for Directors to protect them from personal liability for debts incurred by an insolvent company in certain circumstances.

Why the need for Safe Harbour

Prior to the amendments, the provisions of the Corporations Act governing corporate insolvency focused on the need for Directors to appoint Voluntary Administrators of a company if they suspected that the company was insolvent in order to avoid the risk of the Director being found personally liable for debts that the company incurred whilst it was trading insolvently.

The appointment of a Voluntary Administrator is frequently followed by the appointment of a Liquidator and results in the total loss of any goodwill of the business of a company and the fire sale of assets and little or no recovery of debts for unsecured creditors.

The purpose of the Safe Harbour provisions is to encourage a culture of restructuring in Australia by offering protection to Directors who are proactively taking steps to achieve a better outcome for the company than the outcome likely to flow from the immediate appointment of an Administrator or Liquidator.

The new Safe Harbour provisions are found in Section 588GA of the Corporations Act and effectively provide a carve out from the existing insolvent trading regime in Section 588G.

Insolvent trading & Directors' Personal Liability

Under Sections 588G(2) and 588M of the Corporations Act, a Director of a company to whom the Safe Harbour provisions do not apply is personally liable for loss or damage that a creditor suffers in relation to a debt where:

  1. The company was insolvent at that time the debt was incurred, or became insolvent by incurring the debt, There were reasonable grounds for suspecting that the company was insolvent or would so become insolvent, and
  2. The Director was aware at that time that there were such grounds for so suspecting, or a reasonable person in a like position would be so aware. Under the general insolvent trading provisions, the Director is effectively liable for the unpaid debt owed to the creditor where the Director fails to prevent the company from incurring the debt in the above circumstances.

Significantly, contraventions of Section 588G may also give rise to a monetary penalty.

When is a Company Insolvent

Generally, the test for determining whether a company is insolvent is whether the company is able to meet its debts as and when they fall due. In accounting terms, the test for insolvency is based on the company’s cash flow, but the Balance Sheet should not be overlooked.

Courts determine insolvency by considering a company’s financial position as a whole. This requires an examination of the commercial reality of what resources the company has available to meet its debts, and whether, and if so when, those resources can be realised, either by sale or as security for a loan.

What is "Safe Harbour"?

A Director will be safe harboured from the provisions of Section 588G(2) of the Corporations Act if:

  1. At a particular time after the Director starts to suspect the company may become or be insolvent, the Director starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company, and
  2. The debt is incurred directly or indirectly in connection with any such course of action during the Safe Harbour period.

As Safe Harbour may, however, apply from the time that a Director suspects that a company is or may become insolvent, it is recommended that Directors act promptly to ensure the Safe Harbour applies as soon as they have any concerns about the company’s ability to pay its debts as and when they fall due.

For the purposes of working out whether a course of action is reasonably likely to lead to a better outcome for the company, the Courts may have regard to whether the Director is:

  1. Properly informing themselves of the company’s financial position,
  2. Taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay all of its debts,
  3. Taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company,
  4. Obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice, or
  5. Developing or implementing a plan for restructuring the company to improve its financial position.
What is a Better Outcome

Better outcome” for the company, means an outcome that is better for the company than the immediate appointment of an Administrator, or Liquidator, of the company. In most cases the appointment of an Administrator or Liquidator of a company will result in the complete or substantial loss of the value of goodwill of a business and the realisation of assets for fire sale values only. Depending on what secured creditors exist and the business or assets of the company, Voluntary Administration or Liquidation will, therefore, result in a shortfall for secured creditors and no return to unsecured creditors at all.

The early evaluation of the company’s financial position and an assessment of the likely outcome of the Administration or Liquidation of the company are essential for maintaining Safe Harbour protection and assessing whether proposed courses of action are reasonably likely to lead to a better outcome.

However, as the outcome for a company and its creditors of Administration or Liquidation is often dire, any restructuring outcome that is likely to result in an improved return for creditors, whether by a turnaround or sale of business (and goodwill) or assets for market value (as opposed to a fire sale situation), will be a better outcome for the company.

What is Restructuring?

Restructuring is a corporate management term for action taken to reorganise or change operations, structures or financial accommodation of a company for the purpose of making it more profitable, better organised for its present needs or the elimination of financial harm.

Restructuring activities can range from small projects aimed at improving efficiency and profitability, to more detailed transformational processes, such as asset or business divestments and/or managed wind downs. The courses of action that, therefore, might form part of a Restructuring Plan will depend on the company’s particular circumstances but may include:

  • Operational restructuring, to identify causes of operational underperformance and develop strategies to improve performance.
  • Debt refinancing or consolidation.
  • Financial restructuring via negotiations with creditors and/or the conversion of debt to equity.
  • The sale of a business or asset(s).
  • Wind down of a business.
  • Voluntary Administration.
  • A Deed of Company Arrangement.
Conditions for Safe Harbour Protection

A Director will not be eligible for Safe Harbour protection in relation to a debt if, when the debt is incurred, the company is failing to:

  1. Pay the entitlements of its employees (including superannuation contributions), by the time they fall due, or
  2. Meet its taxation law reporting requirements, and such failure amounts to less than substantial compliance with the relevant matter or is one of two or more such failures by the company during the 12 month period prior to the debt being incurred.

Generally, in order for a Director to enter into Safe Harbour the company must, therefore, ensure that all outstanding employee entitlements are paid and that all returns, notices, statements or other documents required to be lodged under taxation laws are lodged.

Thereafter, there must be substantial compliance with the company’s obligations in relation to the timely payment of employee entitlements and taxation law reporting requirements.

Period of Safe Harbour Protection

The Safe Harbour protections under Section 588GA will, subject to the above conditions, commence when a Director who has begun to suspect that the company may become or be insolvent starts developing a course of action that is reasonably likely to lead to a better outcome for the company and will continue thereafter until the earlier of the following times:

  1. If the Director fails to take any such course of action within a reasonable period after that time – the end of that reasonable period,
  2. When the Director ceases to take any such course of action,
  3. When any such course of action ceases to be reasonably likely to lead to a better outcome for the company, and
  4. The date of appointment of an Administrator, or Liquidator, of the company.
Appropriately Qualified Advisors

The obtaining of advice from an appropriately qualified entity is one of the circumstances that the Courts may consider in working out whether a course of action is reasonably likely to lead to a better outcome for the company. There is, however, no definition of ‘appropriately qualified entity’ in the Corporations Act. An appropriately qualified entity would conceivably include:
• An Insolvency Lawyer,
• A Business Accountant,
• A Turnaround Management Specialist,
• An Insolvency Practitioner (Company Administrator/Liquidator), and
• Other business advisors.

PART II What Directors who suspect Insolvency should do

This information is intended to provide general comment and practical suggestions in relation to what a Director who suspects that their company is or may become insolvent should do to obtain Safe Harbour protection from claims for personal liability for insolvent trading.

It should, however, be noted that the Safe Harbour will not relieve a Director from personal liability arising in relation to any ATO Director Penalties under the Taxation Administration Act 1953. If you have received a Director Penalty Notice or your company has not reported PAYG withholding or Superannuation Guarantee Charge liabilities within three (3) months of the due dates you should seek urgent legal advice.

What should Directors who suspect Insolvency do

A Director who suspects that a company is or may become insolvent should:

  1. Consult an experienced Insolvency & Restructuring Lawyer for preliminary advice.
  2. Pass a Safe Harbour Resolution of Directors (see below).
  3. Verify that all Returns, Activity Statements or the like required to be lodged under any taxation laws have been lodged or immediately take steps for any outstanding items to be lodged promptly.
  4. Verify that all employee entitlements that are due and payable have been paid.
  5. If any employee entitlements are overdue, if possible, pay outstanding entitlements or seek urgent advice from an experienced Insolvency Lawyer and/or Business Accountant.
  6. Take prompt steps to ensure that the company records are up-to-date and that current Management Statements are available for the Directors and their advisors to properly evaluate the company’s financial position and to give appropriate advice in relation to viable restructuring options and outcomes.
  7. Develop a Preliminary Restructuring Plan (see below).
  8. Defer incurring any fresh debts or unnecessary expenses until an appropriate and viable Restructuring Plan is identified.
  9. Directors of SME’s who might be willing to advance their own funds to the company to meet short term cash flow requirements should only do so where the advance is made pursuant to a written Loan Agreement granting security over the company’s assets for repayment of the loan.
  10. Adopt and implement a Restructuring Plan (see below) within a reasonable time if insolvency continues to be an issue.

It should be noted that Directors who seek to rely upon the Safe Harbour provisions bear the evidential burden of adducing or pointing to evidence establishing the actions taken by them to enter and remain under the Safe Harbour protections in order to avoid personal liability that might otherwise arise in connection with debts incurred whilst the company was trading insolvently.

Directors should, therefore, be mindful of keeping records and making notes in relation to all actions they take in pursuance of a restructuring plan and better outcome for the company starting with the seeking out of this information.

Safe Harbour Resolution

A Safe Harbour Resolution is simply a Resolution of Directors invoking or purporting to invoke Safe Harbour protection. The Resolution ensures that there is a clear record, at the earliest stage, of the commencement of the Safe Harbour period.

Preliminary Restructuring Plan

The Preliminary Restructuring Plan should at least initially address the Directors’ intentions and timeframes for:

  • Obtaining advice in relation to whether Safe Harbour is available and/or is applicable, Updating the company’s financial records,
  • Reviewing the company’s budget and cash flow projections,
  • Obtaining advices from appropriate advisors in relation to restructuring options and better outcome opinions,
  • Communications with stakeholders,
  • Undertaking an internal audit to attempt to identify any misconduct by Directors or employees,
  • Developing a detailed Restructuring Plan (see below), and
  • Passing a further Resolution of Directors affirming the invoking of the Safe Harbour protection and adopting one (1) or more courses of action to be developed and implemented as part of a Restructuring Plan or, alternatively, the appointment of a Voluntary Administrator.

This does not need to be a lengthy or complex document. However, the swift preparation of a Preliminary Restructuring Plan will typically be critical for establishing the Safe Harbour in the event of a future claim against the Director for insolvent trading.

The primary purpose of the Preliminary Restructuring Plan is to ensure that:

  1. The essential steps needed to be taken to obtain and stay under Safe Harbour protection are taken within a reasonable time, and
  2. There is clear documented evidence of the further initial steps that the Director is taking to develop one or more courses of action that are reasonably likely to lead to a better outcome for the company.
Dealing with Creditors

Significantly, Safe Harbour protection does not operate to stay any action that any creditors might take or be in the process of taking in relation to any debts. It follows that Directors should be conscious of the need to:

  • act swiftly to invoke the Safe Harbour and to start developing a Restructuring Plan as soon as they suspect the company may be insolvent,
  • act swiftly to develop and implement the Restructuring Plan, and
  • where appropriate, communicate with creditors (usually via a Solicitor) with a view to negotiating, where possible, stand-still arrangements whilst the Restructuring Plan is developed and implemented.
The Restructuring Plan

The Restructuring Plan is the primary document that will set out:

  • what courses of action the Directors have already taken,
  • the restructuring options considered,
  • the advices and better outcome opinions obtained,
  • details of the course (or courses) of action that the Directors intend to take that are reasonably likely to lead to a better outcome for the company, and
  • the approximately timeframes for the taking of such action.

The Restructuring Plan should be developed and implemented with the assistance of appropriately qualified persons. The advisors that may be appropriate will ultimately depend on the financial position of the company and the restructuring strategy to be adopted and implemented, however, will typically involve an Insolvency Lawyer, Business Accountant and Insolvency Practitioner.

Of course, if the Director no longer suspects insolvency the actual preparation and implementation of a Restructuring Plan will not be necessary as the courses of action already taken will have both addressed the company’s financial position and ensured that the Director is Safe Harboured from any future insolvent trading claim (as far as possible).

The Restructuring Plan should also be reviewed frequently to ensure that Safe Harbour protection is not lost because it has become apparent that proposed course of action
is no longer reasonably likely to lead to a better outcome. The there becomes any question whether a course of action will lead to a better outcome within a reasonable time, additional and/or alternate courses of action should be considered and a revised Restructuring Plan prepared and implemented, if necessary.

Privileged Communications & Evidence of Insolvent Trading

It is important that Directors are aware and appreciate that communications with Lawyers are subject to legal professional privilege. This means that such communications cannot
ordinarily be obtained under compulsion of law and used in evidence in any proceedings brought against the Director.

This is particularly relevant as early communications with any advisor who is not a Lawyer and which evidence the extent of a Director’s state of awareness or the period of a company’s insolvency could be used against them in actions for insolvent trading where Safe Harbour is not available and/or before the Safe Harbour period commences.

What Next?

If you already suspect that your Company is or may shortly become insolvent don’t delay.

We have template a Safe Harbour Resolution and a Preliminary Restructuring Plan that may assist to immediately secure Safe Harbour protection for all Directors of the Company.

For more information or assistance call and speak to one of our Insolvency & Restructuring Lawyers today.

Key Practice Contact
Managing Director
Accredited Specialist (Commercial Litigation)