A Safe Harbour for Directors? Shielding against personal liability for insolvent trading

The Australian Government’s Productivity Commission, tasked with independent research and advisory on various economic, social and environmental issues, has recommended amendments to the Corporations Act 2001 (Cth) (Act) which will introduce a ‘safe harbour’ for company directors facing personal liability for insolvent trading.

Introduction

The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 was introduced into the House of Representatives in early June of 2017 and is currently before the Senate, with a second reading having been moved on 22 June. This legislation aims to, among other things, provide protection for company directors in circumstances where looming insolvency provides little room for movement. Current law imposes a duty upon directors to avoid insolvent trading, and a contravention of the insolvent trading provisions may leave a director personally liable for debts incurred by the company. These provisions often leave directors with no option than to enter voluntary administration prematurely, for fear of personal exposure. The proposed legislation aims to provide a safe harbour allowing directors to explore restructuring options without liability under the Act, thus avoiding the destruction of many potentially viable endeavours.

The current position

In its Draft Report on Business Set-up, Transfer and Closure, the Productivity Commission noted that while most governments are more interested in the establishment and survival of businesses rather than their closure, there is a perception that the current insolvency regime provides little incentive to restructure, instead focussing on penalising corporate failure. The current insolvent trading laws effectively command directors towards an often hasty appointment of an external administrator in order to minimise personal liability.  In doing so, the regime, in practical terms, often stymies any commercial steps that may otherwise have been considered to circumvent temporary financial difficulty, thus discouraging directors of struggling, yet often viable companies against options other than administration.

The current, and relatively unforgiving defences to insolvent trading can be found in section 588H of the Act.  The proposed amendments become particularly relevant to a number of those defences.  First, we briefly describe the present scope of these defences.

Section 588H(2): Reasonable grounds for solvency

It is a defence where, at the time the relevant debts were entered into (that is, debts occurring while a company is insolvent), a director had reasonable grounds to expect, and did expect, that the company was solvent and would remain solvent. When determining whether a director had reasonable grounds to expect solvency, an objective standard is applied to the facts known to the director at the time the relevant debts were incurred.  Accordingly, this defence is not appropriate for directors who base an expectation of solvency upon the prospect that the company may trade profitably in the future should continuing trade be allowed. Similarly, an expectation of solvency requires an expectation that all debts can be paid when they fall due, rather than knowledge that funds may become available at an indefinite future time. While a lack of liquidity will not conclusively prove insolvency, any matter which establishes a director knew (or ought reasonably to know) that the company was insolvent will undermine any conclusion which suggests otherwise.

Section 588H(5): Reasonable steps to prevent the incurring of debt

A director may establish that reasonable steps were taken to prevent the company from incurring the debts while insolvent. In determining whether reasonable steps were taken, whether the director took action in considering or appointing an administrator is a primary factor and provides the strongest grounds for relying upon the defence. Similarly to the defence afforded under section 588H(2), the ‘reasonable steps’ defence will bar a director looking for sanctuary in circumstances where trade has continued during insolvency.

The current defences offered under section 588H, as drafted, make it somewhat difficult for directors to work a company out of imminent insolvency as the concept of the reasonable belief is so nebulous. Directors working honestly and diligently in attempting to trade out of insolvency are left exposed, with no current defence in place to afford protection. In these circumstances, the “last resort” for directors is reliance on the final remedies provided by sections 1317S and 1318 of the Act; section 1317S in particular allows for the Court to excuse a company officer from liability where it would be unjust and oppressive not to do so. In this regard, section 1317S acknowledges that officers of a company are businesspeople, acting in an environment which involves high risk and commercial decision making: Daniels v Anderson (1995) 37 NSWLR 438. Regardless, reliance on this remedy carries with it an admission of wrongdoing, in providing relief from an established breach of the Act.  Further, history suggests that these provisions, although relied on from time to time, almost always never succeed.

The proposed legislation

The ‘safe harbour’ legislation proposes the following key points:

A better outcome for the company

A director will be afforded time to consider all available options in guiding the company through circumstances of financial difficulty. In doing so, they will be required to develop an effective course of action, being action which must be ‘reasonably likely to lead to a better outcome for the company’ rather than for the company’s creditors should administration or liquidation be an option. The phrase ‘reasonably likely’ requires a fair or sufficient likelihood, one which is not fanciful or remote. Additionally, a ‘better outcome’ is defined as one which is better for the company than an immediate administration or liquidation.

‘Developing’ a course of action in this context will require more than mere contemplation, and includes taking active steps towards a definite action. A director who takes a passive approach, and who hides behind ignorance of the company’s affairs, will not be afforded a safe harbour.

Liability for debts

A director will only be liable for debts incurred while the company is insolvent where it can be established that the course of action was one which was not reasonably likely to lead to a better outcome for the company. Protection against liability also extends to debts incurred both ‘directly or indirectly’, extending to ordinary debts incurred though the usual course of trade as well as debts incurred through attempts at restructure, but does not extend to debts beyond those incurred in connection with the chosen course of action.

Further, the legislation aims to protect holding companies from liability resulting from debt incurred by a subsidiary, where the directors of that subsidiary enjoy the benefit of the safe harbour and the holding company took reasonable steps to ensure that benefit.

Period of the safe harbour

A director will be afforded protection under the safe harbour provisions from the time that the director, after beginning to suspect the company may be insolvent, starts to ‘develop’ a course of action likely to lead to a better outcome. The time afforded will include that which may be required to obtain initial advice, as well as to plan and ultimately decide on the best course of action. In order to remain within the safe harbour, a director must then implement the chosen course of action ‘within a reasonable period’.

Protection under the safe harbour will end where the director ceases the chosen course of action, or where that course of action is no longer reasonably likely to lead to a better outcome.

Restrictions

The safe harbour will not be available to directors of companies who fail to attend to certain legal obligations, including the payment of employee entitlements and complying with taxation reporting obligations. Further, a director may not rely on the company’s books of account as evidence of a safe harbour, if those books of account have not been provided to a liquidator or administrator as subsequently appointed.

Going forward

It is important to note that the Bill clarifies the ‘safe harbour’ legislation as a ‘carve out’ rather than a complete defence to insolvent trading, allowing scope for directors to rescue a company close to insolvency without facing personal liability. The flexibility of the proposed legislation may allow a director to continue trade where a positive expectation of solvency is unclear, but where a reasonable likelihood of a better outcome for the company (rather than the company and its creditors) exists.

There is no doubt that the current legislative framework involving insolvent trading acts as a successful deterrent, one which aims to protect the unsecured creditor against precarious financial conditions and avoids self-serving strategic behaviour. While a cautionary stance is necessary, it must also be carefully balanced with the need to uphold entrepreneurial spirit, allowing directors to retain control of their company and take reasonable risks in order to facilitate recovery rather than failure. To this end, the proposed legislation may serve as a welcome addition to insolvency legislation, encouraging a more positive and proactive approach to attempts at rehabilitating and recovering companies in the face of financial difficulty.

Co-authored by Charmaine James and Paul Mac