In this article, we look at two key changes that will help distressed companies avoid voluntary administration or liquidation:
- The new minimum amounts and limits for statutory demands for payment of debt, and
- The new ‘temporary safe harbour’ for businesses dealing with the Coronavirus pandemic.
Listen to Ben Sewell interviewed for the Tax Talks podcast on the COVID-19 changes to debt recovery policy.
Increasing the allowable default amounts for debtors
The most common way for an unpaid creditor to initiate the winding up of a company is to issue a statutory demand for payment of debt (statutory demand). If the debtor fails to pay a demanded amount within a certain period of time, they can be deemed insolvent and winding up proceedings can be initiated.
- The amount that the creditor must be owed before issuing a statutory demand has risen from $2,000 to $20,000; and
- The previous period of 21 days for a debtor to respond to a statutory demand has now been extended to six months.
How the new default arrangements help distressed companies
One word: time. Under previous arrangements, businesses had very little time to work with lawyers, accountants and insolvency practitioners to re-organise or restructure their business before creditors could initiate proceedings to wind up the company. The new provisions mean that companies have time to:
- Seek or advance more working capital. For example, companies will have more time to acquire financing via the Coronavirus SME Guarantee Scheme which will make it easier for small and medium-sized enterprises (SMEs) to access business loans to tide them over.
- Obtain reliable financial information about the company. Many distressed companies are not on top of their financials and how they might reduce costs and increase cash flow. They will now have time, for example, to consider the new Instant Asset Write-Off and depreciation rules introduced by the Government.
- An alternative to using formal processes (such as voluntary administration or small business restructuring) is to undertake a pre-pack-insolvency arrangement. This restructuring method is unconventional in Australia and is not universally accepted in the insolvency industry as appropriate. The method involved undertaking asset transfers before a formal insolvency (such as liquidation) is commenced to save a business.
A cautionary note: Other than the change to statutory demands, existing mechanisms for liquidating companies remain unchanged. This means, for examples, a creditor can still pursue a wind-up through a judgment debt.
Temporary relief from director liability for insolvent trading
Section 588G of the Corporations Act 2001 prohibits company directors from trading while insolvent and holds them personally liable if they do not comply. This means that, even where creditors are not pursuing the wind-up of the company, directors are not safe from liability. This generally leads to directors being ‘trigger happy’ when it comes to appointing a voluntary administrator or liquidator, for fear of breaching this provision. The Coronavirus Economic Response Act provides temporary respite or ‘safe harbour’ from this prohibition via new section 588GAAA of the Corporations Act 2001. The new temporary safe harbour applies if:
- the debt is incurred in the ordinary course of business;
- the debt is incurred in the six-month period from when the law comes into effect;
- the debt is incurred before the appointment of the voluntary administrator or liquidator.
There is no definition in the new section as to when a debt would be incurred in the ‘ordinary course of business’. However, the Explanatory Memorandum accompanying the Coronavirus Economic Response Act suggests that the debt must be “necessary to facilitate the continuation of the business” (See paragraph 12.18). Examples listed in that Memorandum include:
- taking out a loan to move the business online;
- debt to pay employees during the Coronavirus pandemic.
It is worth noting that under the new section of the Corporations Act 2001, the evidential burden of proving compliance with this safe harbour lies with the directors that seek to use it.
What does the temporary safe harbour mean for directors?
It means directors don’t have to pull the trigger and appoint a voluntary administrator or liquidator. Or, at least, not as quickly. This is good news for everyone: voluntary administrations have an abysmal success rate. The eventual outcome result is usually a wound-up enterprise and chicken-feed for creditors.
Note, however, that the temporary safe harbour is not a ‘get out of jail-free card’. There are still a range of duties that apply to directors that they are not exempt from, including:
- The duty under section 181 of the Corporations Act 2001 to act honestly, in good faith and in the interests of the company;
- The duty under section 182 of that Act not to improperly use their position to gain an advantage for themselves.
Any director that attempts to use this insolvency relief in order to engage in illegal phoenix activity – transferring assets to another business for less than market value, cooking the books, or committing fraud will be in big trouble. Both regulators and the general public take a very dim view of anyone who exploits a crisis situation.
Directors must also pay attention to the ‘ordinary course of business’ restriction. Companies will need to carefully consider whether to use this temporary safe harbour mechanism in order to restructure or to whether to use existing safe-harbour provisions that are more specifically aimed at re-structuring activities.
- The Coronavirus Economic Response Act increases the minimum amount for a statutory demand for payment of debt from $2,000 to $20,000. It increases the response period for the debtor company from 21 days to six months. This change gives debtor companies valuable time to work their way through financial distress;
- The Coronavirus Economic Response Act also creates a new ‘temporary safe harbour’ which protects directors from liability for insolvent trading while they respond to the Coronavirus pandemic and its consequences.
These mechanisms may create a useful opportunity to re-organise or re-structure and save your business, but there are still legal risks to doing so. Therefore, obtaining professional advice is paramount.