Safe Harbour & Directors’ Liability for Insolvent Trading

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.

Frequently, the appointment of a Voluntary Administrator is 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. Too often, the outcome of such appointments is that unsecured creditors receive little or no recovery of debts they are owed by the company.

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:

• 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
• 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.

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.

What is “Safe Harbour”?

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

• 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
• The debt is incurred directly or indirectly in connection with any such course of action during the safe harbour period.

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:

• Properly informing themselves of the company’s financial position,
• 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,
• Taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company,
• Obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice, or
• 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:

• Pay the entitlements of its employees (including superannuation contributions), by the time they fall due, or
• 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:

• If the Director fails to take any such course of action within a reasonable period after that time – the end of that reasonable period,
• When the Director ceases to take any such course of action,
• When any such course of action ceases to be reasonably likely to lead to a better outcome for the company, and
• 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:

• A Business Accountant,
• An Insolvency Lawyer,
• An Insolvency Practitioner,
• A Turnaround Specialist, and
• Other business advisors with relevant and adequate qualifications or experience with business, insolvency and restructuring.

As the categories of advisors that may be considered an appropriately qualified entity for the purposes of Section 588GA are potentially very broad, the class of advisors who might, therefore, be expected to be able to advise a Director of a company of the need to invoke the Safe Harbour protections, and who consequently might be found to owe a common law duty of care to provide such advice, is equally broad.

The implication of this is that Accountants, Lawyers or other business advisors who fail to provide timely advice to Directors in relation to Safe Harbour protections and the need to take early action to develop and implement a Restructuring Plan may become the target of professional negligence actions brought by Directors facing personal liability for insolvent trading in circumstances where that liability might have otherwise been avoided had the Safe Harbour protections applied.

What should Directors who suspect Insolvency do

It is important that Directors, and their other advisors, 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.

If a Director suspects that a company is or may become insolvent, the Director should:

• Consult an experienced Insolvency Lawyer for preliminary advice.
• Pass a Safe Harbour Resolution of Directors invoking or purporting to invoke Safe Harbour protection to ensure that there is a clear record, at the earliest stage, of the commencement of the Safe Harbour period.
• 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.
• Verify that all employee entitlements that are due and payable have been paid.
• If any employee entitlements are overdue, if possible, pay outstanding entitlements or seek urgent advice from an experienced Insolvency Lawyer and/or Business Accountant.
• 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.
• Develop a Preliminary Restructuring Plan that should at least initially address the Directors’ intentions and timeframes for:

1. • 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 Restructuring Plan detailing one (1) or more courses of action that are reasonably likely to lead to a better outcome for the company and the approximately timeframes for the taking of such action, 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.

• Defer incurring any fresh debts or unnecessary expenses until an appropriate and viable Restructuring Plan is identified.
• Further, 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.

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.

Next, with the assistance of appropriate advisors, the Directors should develop a complete Restructuring Plan detailing one (1) or more courses of action that the Directors intend to take that are reasonably likely to lead to a better outcome for the company and implement (and further develop, if necessary) that Restructuring Plan within a reasonable period. The Restructuring Plan should briefly summarise the restructuring options and better outcome opinions considered and include relevant advices that the Directors have obtained.

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.

Finally, 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.

Implications for Accountants, Lawyers and other Advisors

Accountants, Lawyers and other advisors who have an ongoing retainer or relationship with a company and its Directors need to be wary that their common law duty of care owed to Directors now extends to advising Directors in relation to:

• the available safe harbour laws, and
• the need to promptly develop and implement a plan for restructuring the company if the Director suspects insolvency.

Where insolvency is suspected, advisors would also be expected to act promptly to assist Directors to invoke the safe harbour protections and to develop and implement a Restructuring Plan within a reasonable time.

From a litigator’s perspective, advisors who are not familiar with safe harbour protections, and/or who fail to provide Directors of companies with appropriate advice at the earliest possible time face, the risk of actions for professional negligence by Directors against whom a claim for insolvent trading might subsequently be brought by a Liquidator of the company. Significantly, as the requirements for invoking safe harbour are relatively low, it is likely that in most cases Directors might have been easily able to invoke safe harbour protections had appropriate advices been given and that, therefore, the risk for advisors who fail to give appropriate advice is significant.

Advisors who are, therefore, not experienced or comfortable advising Directors in relation to these matters should promptly refer the Director to a Lawyer and/or Accountant experienced with insolvency and restructuring.

In order to assist Accountants, General Practitioners and other business advisors to provide appropriate early advice to Directors, we have developed a short Information Sheet and sample Safe Harbour Resolution available on request, which we recommend be provided to Director clients promptly if there is any reason to suspect that the company is or may become insolvent.