Australia: Safe harbour defence unveiled: insolvency law reform to save businesses and jobs

What you need to know

• The Federal Government has released long-anticipated draft legislation making key changes to insolvency laws in Australia.
• The proposed changes affect directors' liability for insolvent trading, as well as 'ipso facto' clauses.
• We unpack and put the proposed changes in context, look ahead to the changed insolvency landscape for directors and restructuring advisers, and call for Federal Parliament to support these important reforms as they will assist with the successful restructure of businesses and ultimately save jobs.

Australia's current insolvent trading laws and lack of protection against 'ipso facto' clauses can make certain restructurings and workouts far more difficult than they need to be. Reform is necessary to ensure Australian businesses maintain a commercial edge in a fast changing economy affected by digital and other disruption.

Co-author John Stragalinos has previously called for the Federal Government to reform Australia's onerous insolvent trading laws to foster innovation and encourage entrepreneurship. This update examines the proposed changes that were unveiled last week, after a long period of anticipation.

Corporate insolvency

Australia's current insolvent trading laws mean directors (including non-executive directors) face personal liability when their company is in severe financial difficulties and they are confronted with a necessary financial restructure. In recent years there has been a dramatic increase in restructures undertaken by restructuring and turnaround professionals in Australia drawing upon experiences in the USA and UK: for instance Alinta and McColl's Transport.

Currently directors must prevent their company from incurring debts where the company is insolvent, or becomes insolvent by incurring the debt and at that time, there are reasonable grounds for suspecting the company is insolvent, or would become insolvent. Failing to guard against insolvent trading may result in the director being personally liable for debts incurred while the company was insolvent.

On 28 March 2017, the Federal Government released draft legislation which proposes to:

• create protection (a 'safe harbour') for company directors involved in restructuring a business by protecting them from personal liability for insolvent trading claims under certain conditions
• make 'ipso facto' clauses unenforceable.

Safe harbour from insolvent trading

In short, if directors take appropriate steps, such as obtaining expert advice and preparing a restructure plan that is reasonably likely to lead to a better outcome than an insolvency appointment, they can protect themselves from liability for insolvent trading.

Under the proposed reforms, directors will enjoy protection (a safe harbour) if they take a course of action that is reasonably likely to lead to a better outcome for the company and the company's creditors as a whole than proceeding to immediate administration or liquidation. The inclusion of certain conditions (eg the need to maintain books and records and provide for employee entitlements) should help guard against abuse of the provisions.

In determining whether a course of action is reasonably likely to lead to a better outcome for a company and its creditors, the following actions by directors may be considered:

• taking appropriate steps to prevent misconduct by officers or employees
• obtaining appropriate advice from a suitably qualified adviser who was given sufficient information to give appropriate advice
• taking appropriate steps to ensure the company is keeping appropriate financial records
• properly informing themselves of the company's financial position
• developing or implementing a restructuring plan to improve the company's financial position.

It is not necessary for all factors to apply and other matters may be considered. One would expect that seeking appropriate advice will become an important factor in practice.

In our view, the proposed safe harbour reforms should provide numerous benefits by:

• encouraging directors to engage early and seek appropriate advice from a restructuring/ turnaround expert to form a restructuring plan, rather than placing their company prematurely into administration
• allowing directors to trade through financial difficulties and take reasonable risk as they embark on a restructure without the fear of personal liability
• providing the company and its stakeholders (financiers, employees, creditors and shareholders) with time to prepare and implement a restructuring plan without the threat of the directors being forced to place the company into administration due to their personal exposure
• providing a company's restructuring advisers and key stakeholders time to prepare and implement a restructuring plan
• avoiding the value destruction that occurs with the appointment of an administrator or receiver.

Ipso facto clauses

In broad terms, an ipso facto clause allows one party to terminate or modify the operation of a contract upon the occurrence of a specific event (eg the appointment of an administrator).

Ipso facto clauses can lead to the destruction of value in a restructuring and prevent the successful sale of a business as a going concern. The proposed changes to the enforcement of ipso facto clauses will assist in restructuring businesses in financial trouble.

The proposed legislation applies to stay the enforcement of ipso facto clause rights in relation to:

• a relevant entity that applies for a scheme of arrangement or compromise
• companies that enter into voluntary administration.

The stay will apply regardless of whether the right to terminate or amend the contract is self-executing or triggered by one of the parties to an agreement. The courts will have the discretion to allow a right to be enforced if doing so would be in the interests of justice.

Subject to a court ordering otherwise, the stay on ipso facto clauses will have no impact on a party's right to terminate a contract for any other reasons, for instance, a breach for non-payment. The courts will have the discretion to restrict such enforcement if it appears likely those rights will be exercised merely because of an insolvency event.

Importantly, the Federal Government has indicated that the changes will not affect some contracts and instruments, including bank loan documents and other financial products (eg swaps).

What should directors do now?

Reform to Australia's insolvent trading laws and ipso facto provisions are very important in the current climate of business disruption. We call upon Federal Parliament to support these important reforms as we strongly believe they will assist with the successful restructure of businesses and ultimately save jobs.

In the meantime, regardless of whether the proposed reforms are passed or not, the message to directors of a company in financial difficulty is simple:

If a company is in financial difficulty due to changes in economic conditions, disruption from a new competitor or poor decisions being made, the board of directors should be proactive and act early. Directors should obtain appropriate advice from a turnaround/ restructuring expert and engage with their stakeholders. This will maximise the chance of a successful restructure and minimise the risk of liability for insolvent trading.

This article is intended to provide commentary and general information. It should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this article. Authors listed may not be admitted in all states and territories