Any port in a storm? Analysing safe harbour and ipso facto insolvency reforms - Financial Restructuring

Much has been written and discussed about Australia's draconian insolvent trading laws and the Federal Government has taken note. It has released draft legislation seeking to amend the Corporations Act in a way that supports the restructuring of financially distressed companies. But do these amendments go far enough in providing companies with the time and space they require when they're seeking to implement a financial restructuring plan?

BACKGROUND

The ( Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017) (the Bill) introduces:

a 'safe harbour' for directors who are seeking to develop or implement a restructuring of a company. This will see the directors shielded from personal liability for insolvent trading under section 588G of the 2001 (Cth) (Corporations Act); and
a stay on the enforcement of 'ipso facto' clauses in a contract that are triggered when a company enters formal insolvency proceedings.

The ipso facto reforms will take effect from 1 January 2018, while the safe harbour reforms do not yet have an implementation date but may take effect earlier than 1 January 2018.

SAFE HARBOUR FROM PERSONAL LIABILITY

It's widely accepted that reform in this area is required to increase the chances of turning around viable (or potentially viable) companies in the zone of insolvency (or the 'twilight zone') without the fear of personal liability for directors.

Under the current legislative framework, it's understandable that when faced with potential personal liability, directors may seek protection through the appointment of an insolvency practitioner rather than using informal restructuring techniques to turn the company's fortunes around. It is generally accepted that prematurely placing a company into a formal insolvency process can destroy value for key stakeholders (including employees and creditors).

At present, under section 588G of the Corporations Act, a director of a company may be personally liable for debts incurred by the company if, at the time the debt is incurred, there are reasonable grounds to suspect that the company is insolvent or would become insolvent. This duty currently focusses on the timing of when debts are incurred by a company rather than the conduct of the directors in incurring that debt. This focus on timing adversely impacts the decisions of directors and does not give them sufficient means to implement a restructuring.

Several foreign jurisdictions, most notably England, have for some time now moved away from formal insolvencies toward informal restructurings, turnarounds and business rescues. Often this is achieved in a legislative environment which allows directors sufficient breathing space to concentrate on bringing together key stakeholders for the purpose of deleveraging the company's balance sheet and fixing its business operations. This has led to countless numbers of businesses right-sizing their balance sheets at the same time as implementing much needed operational turnarounds.

By removing the liability risk and promoting a culture of entrepreneurship, directors should, as the Explanatory Memorandum to the Bill suggests, be free to innovate and take reasonable risks to restructure viable companies. But do the proposed safe harbour provisions provide sufficient comfort and clarity to directors, as is the case in England? Are they encouraged to trade through the twilight zone in the hope of safe harbour protection?

To benefit from the safe harbour protection in the proposed new section 588GA, which will act as a carve out to section 588G(2) liability, a director will need to overcome four hurdles to ensure the director will not be personally liable for newly incurred debts.

Better Outcome

The first hurdle is for directors to "start taking a course of action that is reasonably likely to lead to a better outcome for the company and the company's creditors". A 'better outcome' is one where the company and its creditors as a whole are better off compared to the company going into administration, receivership or being wound up.

Importantly, the safe harbour can still apply to a director where the ultimate result of taking on further debt is formal insolvency. Provided that the director was pursuing a reasonable course of action which was likely to lead to a better outcome then the director will still have the benefit of safe harbour.

There is a list of non-exhaustive factors (as a guide only) to consider when determining whether a course of action is reasonably likely to lead to a better outcome. These include whether the director is: (i) obtaining appropriate advice; (ii) ensuring the company is keeping appropriate financial records; and (iii) developing or implementing a plan for the restructuring of the company to improve its financial position. The Explanatory Memorandum makes it clear that it is not necessary for all of the list of factors to be present to enable the director to rely on the safe harbour and, in fact, it may be possible for the defence to apply even where none of those factors are present.

The Explanatory Memorandum also indicates that the term "the company's creditors as a whole" is intended to cover both existing and new creditors. This may create problems for the directors in terms of assessing the likely outcome of the restructuring for each of these two separate constituencies, especially where each of their interests are not aligned in the particular course of action chosen.

The "better outcome" test is an objective one which will only be tested after the fact and differs from the original proposal which contained a subjective element (see Proposals Paper). Further, directors are not required to "return the company to solvency within a reasonable period of time", which was also a feature of the original proposals. Arguably, this first hurdle may be the easiest to overcome as the section has a wide application to ensure that directors of organisations of any size or nature can potentially benefit from the provisions. They are not required necessarily to incur significant cost in complying with a prescribed list of factors to be afforded protection.

However, the evidential burden rests with the director to demonstrate that the course of action chosen was reasonably likely to lead to a better outcome for the company and its creditors as a whole. The onus will then shift to a liquidator (or a third party who had acquired the cause of action from the liquidator) alleging a breach of section 588G(2), to prove that the safe harbour doesn't apply because the course of action was not a reasonable one.

Importantly, directors will not be able to use books or information as evidence to support a safe harbour defence where these materials have previously been withheld from an administrator or liquidator following an appropriate request for such materials. This is designed to prevent directors from withholding such information to limit investigations into the activities of the company and its directors.

Debts Incurred

The next hurdle will be for the director to establish that the debts incurred were debts incurred in connection with that "better outcome" course of action. If the debt is incurred when the particular course of action is no longer reasonably likely to lead to a better outcome, or when the company has been placed into administration or is being wound up, the exclusion will no longer apply.

It is unclear at this stage whether in overcoming this hurdle, normal trading debts would be considered debts to be incurred in connection with that course of action. Although we would like to assume normal trading debts are to be covered, it is far from clear in the Bill. In connection with any new money financing (which is a typical feature in a financial restructuring), the directors will need to ensure the company can repay that new financing on its terms if they wish to be protected by the safe harbour regime.

Employee Entitlements and Tax Obligations

The third hurdle is created by the additional exemptions to the protection set out in section 588GA(4) of the Bill. Directors will not be able to rely on the safe harbour protection if the company has not made provision for the entitlements of its employees (including superannuation obligations) or is not compliant with its tax reporting obligations in a manner consistent with a company that is solvent.

It is not clear what making provision for entitlements involves but at the very least, it would seem to suggest that entitlements are up to date. Moreover, it is unclear what the purpose is of imposing a compliance standard consistent with a company that is solvent. Keeping employee entitlements up to date or compliance with tax reporting obligations do not form part of the definition of solvency in the Corporations Act, notwithstanding they are factors which are often present in companies with solvency difficulties.

According to a report published by the Australian Securities and Investments Commission in 2010, the majority of external administrations in Australia relate to small to medium proprietary limited companies. It is often a common feature in these administrations that the entities are non-compliant in the areas of employee entitlements and taxation and it is not unusual in these circumstances to see employees and the tax authorities being used as a secondary form of credit.

A key aim of the reform is to reduce the number of unnecessary external administrations for companies which could be successfully restructured. However, this is unlikely to occur if the directors of those organisations are unable to qualify for safe harbour due to the exemptions in proposed section 588GA(4). On the flip side and from a public policy perspective, these exemptions may provide the incentive to directors to make company compliance with employee and tax obligations a priority. It may also lead to directors seeking safe harbour protection earlier which may result in companies also taking the necessary course of actions earlier which ultimately improves the prospects of a successful business turnaround.

Continual satisfaction of safe harbour conditions

The final hurdle, and likely to be the stumbling block for a risk averse director, is the requirement to continually satisfy the conditions of safe harbour at all times during the restructuring process.

Restructurings can be lengthy processes where directors are required to make difficult decisions in often compressed time frames. If at any stage, the company fails to be compliant with respect to employee entitlements or tax reporting obligations, the safe harbour will fall away from that point. Moreover, if at any stage during the restructuring, it becomes clear that the company cannot be viable in the long term, the safe harbour protection will also fall away from that point. Only time will tell whether the distraction of continually monitoring compliance with the safe harbour provisions adversely affects the ability of directors to confidently lead their companies through restructurings.

There are many hurdles to jump for a director in seeking safe harbour during a restructuring process under the proposed legislation. In our view, far too many to take the reform as far as it needed to go to "encourage honest directors to innovate and take reasonable risks" in times of financial distress and crisis.

Alternative framework

In terms of an alternative approach, we question whether it would have been better and easier for the Bill to adopt similar language to that used in section 214 of the Insolvency Act 1986 (UK). That section frames its "wrongful trading" actions against directors by giving courts a discretionary jurisdiction to declare that a director of a company in insolvent liquidation or administration may be "liable to make such contribution (if any) to the company's assets as the court thinks proper". Such a declaration may be made if:

the court is satisfied that the director knew (or should have known) that, at some time before insolvency proceedings began, the company had no reasonable prospect of avoiding going into insolvent liquidation or administration; and
once it had become clear to that director that there was no longer a reasonable prospect of avoiding insolvent liquidation or administration, he or she did not take every step to minimise the potential loss to creditors that they should have taken.

This form of drafting is tried and tested in practice (especially the requirement to "take every step to minimise the potential loss to creditors") and has provided English company directors (as well as their restructuring and insolvency advisers) with the requisite latitude to implement informal restructurings for decades. This approach has less hurdles for directors to jump over yet maintains the requirement for creditors to be protected in restructuring situations, which is consistent with Australian case-law which requires directors to act in the best interests of creditors once the company is approaching (or has entered) the twilight zone.

IPSO FACTO REFORMS

The Bill also contains two new legislative provisions (sections 415D and 451E) to implement a stay on the operation of ipso facto clauses contained in commercial contracts.

An "ipso facto" clause gives one party a right to terminate or vary a contract upon the occurrence of a specific event, such as a counterparty entering into a scheme of arrangement or appointing a voluntary administrator. Generally such clauses operate regardless of whether the company experiencing financial difficulty has been performing its obligations under the contract.

The enforcement of these clauses has long been considered as a hindrance to the implementation of a consensual restructuring due to the limiting effect it has on the options open to the company, the potential destruction of enterprise value or the prevention of a sale of the business as a going concern.

The amendments introduced by the Bill will impose a stay on a party enforcing its contractual rights under an ipso facto clause solely because the other party enters into administration or a scheme of arrangement (but only where the company's scheme application states it is being made so the party can avoid being wound up in insolvency). Notably, the stay does not apply to liquidations or the appointment of receivers. The stay will only operate while the administration or scheme of arrangement is ongoing and will cease when the company is wound up.

The Bill also provides the court with power to order that any rights under a contract are only enforceable with the leave of the court and are subject to conditions imposed by the court. This order can only be made if the court is satisfied that, among other things, a party is exercising or will only exercise the contractual right because the counterparty has entered into a compromise or is in administration.

The overall effect of the amendments is to render unenforceable a clause that allows a party to terminate purely due to a counterparty entering into (or applying for) a scheme of arrangement, or entering into administration. When the legislation applies, the ipso facto clause will be unenforceable regardless of whether it is self-executing or takes effect at a party's election.

Under the Bill, a party cannot be forced to provide additional credit to the other party while the right to terminate or vary the contract is unenforceable. However, each party will still maintain its right to terminate or amend the contract for any other reason, such as a breach of the contract involving non-payment or non-performance.

Carve outs to the Amendments

The amendments will not apply to rights:

in types of contracts specified in regulations (which, according to a document released by Treasury, may include rights of set off, flexible priority arrangements, flawed asset arrangements, master netting agreements, and securitisation arrangements involving special purpose vehicles);
of a kind prescribed in a ministerial determination;
in agreements made after the commencement of a scheme of compromise or the date the company is placed into administration; or
that manage financial risk associated with a financial product that is commercially necessary for that type of financial product (e.g. swaps, where a party is entitled to close out its position so as to manage counterparty risk).

In addition, the Bill provides the court with discretion to lift the stay if:

it would be appropriate in the interests of justice; or
in the case of a scheme of arrangement, the scheme was not for the purpose of the company avoiding being wound up in insolvency.

OVERALL IMPACT

In our view, the restrictions on the enforcement of ipso facto clauses in the form set out in the Bill should be welcomed. They are likely to provide companies with the necessary breathing space they require when seeking to implement a financial restructuring plan.

As is often the case with complex financial restructurings (which seek to turn the company around rather than a terminal liquidation process), it is the financial debt (i.e. senior secured facilities, mezzanine facilities or high yield bonds) that is the cause of the company's financial problems rather than its trade creditor debt. It is generally the financial debt that is restructured (often via an equitisation process) that is the subject of a financial restructuring process. The success of the restructuring plan is often a function of the ability to keep as much of the business together as possible (while implementing a balance sheet fix and operational turnaround). A large part of that process is facilitated by maintaining key contracts to enable the business to run optimally and see it returned to profitability.

By limiting the ability of counterparties to terminate their contracts merely because the company has been placed into administration or is undertaking a scheme of arrangement (while providing contractual counterparties with appropriate protections), the new legislation should enable a company that has improved its financial health to emerge and continue to operate as a going concern. This, in turn, will directly benefit trade creditor counterparties by allowing the contracts to continue which should, all things being equal, lead to greater employment opportunities and mutually beneficial outcomes.

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