Navigating the insolvency safe harbour: Complete guide for SMEs
The safe harbour is a carve-out to the duty of company directors to cease trading when a company is insolvent. It is a pro-business mechanism that helps companies stay afloat by giving directors protection from prosecution for insolvent trading while they work on a restructure. Read our guide to the safe harbour to find out more about this potential lifeline for insolvent companies.
- September 2017 Safe Harbour Provisions
- What is the safe harbour from insolvent trading?
- COVID-19 Temporary Safe Harbour
- Key takeaways for businesses insolvent due to COVID-19 in 2020
- Explanatory video on the safe harbour (2020)
- Interview about obtaining the safe harbour provisions (2018)
- Podcast on the nature of the safe harbour provisions (2018)
- What is the prohibition on insolvent trading?
- When insolvent trading is a crime? Safe harbour exception
- Why is there no turnaround profession in Australia?
- Plan tactics: cost cutting and stabilisation
- Implementing a plan
- Qualifications of solicitors to be an “appropriately qualified entity”
- The same law, different behaviours: Large corporates versus SMEs
- Case study: Condor Blanco Mines’ disclosure to ASX
- Case study: why didn’t Virgin Airlines Australia use the safe harbour to restructure?
- The hurdles to obtaining the safe harbour provisions
- Phoenix activity is not safe harbour restructuring
- Alternatives to the safe harbour provisions
- September 2017 Safe Harbour Summarised
- How does our system compare to Chapter 11 of the US Bankruptcy Code?
- How does our system compare to the UK and ‘wrongful trading’?
- Capstone comment: Is a safe harbour restructure tactical for SMEs?
- Section 588G of the Corporations Act prohibits companies from trading while insolvent, and provides a cause of action for liquidators against company directors
- Insolvency means that the company is not just experiencing a temporary liquidity problem but has a chronic shortage of working capital, the company is unable to pay its debts as and when they fall due and payable
- In order to comply with this requirement, directors had to move to external administration as soon as their company became insolvent to avoid personal liability
- In September 2017, section 588GA was inserted into the Corporations Act
- It stipulates that where a company director suspects insolvency and incurs debts, but those debts are incurred in pursuit of a course of action that is reasonably likely to lead to a better outcome for the company, they shall not be liable under section 588G
- This is not a defence, but a ‘carve out’: liquidators will have no claim against directors sheltering in the safe harbour
- In March 2020, the safe harbour was extended to apply to more businesses, for more time, in recognition of the economic impact of COVID-19, which is expiring at the end of December 2020 after being extended
September 2017 Safe Harbour Provisions
In 2015, the Productivity Commission released an inquiry report calling for, among other things, the introduction of a safe harbour from insolvent trading to allow businesses to safely attempt a restructure. While this was a key catalyst for the September 2017 reform, the government implemented a safe harbour markedly different from the one recommended by the Productivity Commission.
- There was an enormous change in insolvency law in Australia in 2017. The biggest reforms are a “carve-out” to the prohibition on insolvent trading. This means that, theoretically, companies can trade if they are unable to pay their debts, whereas before, they could not.
- These reforms came about in September 2017 so there is little case law on it yet.
- A “carve out” means that the new section 588GA has been added to the Corporations Act 2001 (Cth) which provides: “safe harbour – taking a course of action reasonably likely to lead to a better outcome for the company”.
What is the safe harbour from insolvent trading?
The safe harbour is a pro-business mechanism that helps companies stay afloat by giving directors protection from prosecution for insolvent trading while they work on a restructure. This means that companies that become insolvent can continue to trade, take out loans, and make changes aimed to restructure and revive the business, rather than immediately writing it off as a failure and instigating a formal appointment of a liquidator or voluntary administrator. It recognises the need for businesses to be given a ‘second chance’ to try a different approach and address their profitability.
The safe harbour is the only carve-out to the duty of company directors to cease trading when a company is insolvent. The safe harbour from insolvent trading as it was introduced in September of 2017 represents a significant watering down of the insolvent trading prohibition and is an alternative to a formal appointment of a voluntary administrator or liquidator. The extension of the safe harbour for COVID-19 provides even further allowances for companies seeking to survive the economic storm.
The most widely read report in Australia that recommended a safe harbour from insolvent trading was the Productivity Commission’s Business Set-up, Transfer and Closure Report. The Productivity Commission’s recommendations, however, were not followed by the government. The Commission recommended that a registered “restructuring adviser” take carriage of the safe harbour process and that they follow a set process that included providing a certificate. Under the Productivity Commission model, the restructuring adviser was also required to have a deep knowledge of insolvency. Instead, the government inserted a new section 588GA into the Corporations Act that, compared to the Productivity Commission recommendations, is vague and laissez-faire. The substantial requirements to obtain safe harbour protection include starting to “develop” a course of action for a turnaround, meeting a threshold of filing tax returns on time and paying all employee’s entitlements in full.
COVID-19 Temporary Safe Harbour
The new Coronavirus Economic Response Package Omnibus Act 2020 has just come into force to provide relief to businesses struggling due to COVID-19. One of the key changes is the addition of Section 588GAAA to the Corporations Act 2001. It provides a new, temporary ‘safe harbour’ from the prohibition on directors from trading while insolvent at Section 588G of the Corporations Act.
The safe harbour as it stood before COVID-19 was introduced in September 2017 to help company directors undertake informal company restructures during insolvency. The new COVID-19 provision, while operating on the same principle, is slightly different in its recognition of the new economic challenges presented by the COVID-19 recession.
This new safe harbour applies to protect directors from being held personally liable for trading while insolvent if:
- The debt is incurred in the ordinary course of business;
- The debt is incurred in the six-month period from 24 March 2020 (now extended to apply until 31 December 2020); and
- The debt is incurred before the appointment of a voluntary administrator or liquidator.
While the new section does not define what constitutes the ‘ordinary course of business’, the Explanatory Memorandum suggests that this clause is limited to apply only to debts “necessary to facilitate the continuation of the business”, i.e. taking out a loan to move the business online or a debt to pay employees during the pandemic. It should be noted that this protection, designed specifically for COVID-19, is narrower than the existing regime which protects debts incurred directly or indirectly that are likely to lead to better outcomes for the company. The advantage of the new temporary scheme is its automatic operation until the end of December 2020 (although the evidential burden of proving compliance will lie with the directors seeking to use it).
So, what does this mean for directors? It allows them time and flexibility to invest in restructuring to suit the new economic and social conditions, rather than moving straight to a voluntary administration or liquidation appointment. Essentially, its good news – breathing space to consider the options.
However, while the COVID-19 Safe Harbour may be enough to provide some businesses with sufficient temporary protection, directors will need to be satisfied that once 2021 rolls around they will be able to return to solvent trading. For most businesses in financial trouble due to COVID-19, this extension will not be enough on its own. COVID-19 shows no signs of slowing down, and the economic after effects will only be magnified the longer it continues to force lockdowns and limit buying power, thus shaping market trends through changing consumer behaviour. In this case, directors will need to take long-term steps to manage existing creditors and meaningfully restructure the business.
It should also be noted that directors’ duties still apply and directors must also continue to identify and manage business issues and their impact on creditors. These include the duty to act in the best interests of the company as a whole (this may involve accounting for stakeholders interests beyond creditors), the duty to act with care, diligence and good faith and the duty not to use a director’s position or information obtained from that position to gain an advantage or cause detriment to the company. A recent High Court decision affirmed that these duties also extend to individuals who have the capacity to significantly affect the financial standing of the company.
Directors should look to restructure through refinancing, raising capital, seeking deferrals or payment plans with creditors, reducing costs and focusing business services. Here, it makes sense for directors to prepare a plan which meets the requirements of the 2017 Safe Harbour provisions in order to make sure they will be protected if they are still experiencing issues into 2021.
Key takeaways for businesses insolvent due to COVID-19 in 2020
For directors concerned about whether their trading and debts incurred during COVID-19 are covered by the new temporary measures, consider the following:
- Is the debt necessary to facilitate the continuation of the business during and/or after the pandemic?
- Will the debt be incurred within the operational period of the temporary amendment (24 March 2020 – 31 December 2020)?
- Has there not yet been a formal appointment of a voluntary administrator or liquidator?
- Can you (the director) provide evidence to prove that you have complied with the requirements of the safe harbour (i.e. statements, invoices, payroll, bank reconciliations, a written plan, professional advice, etc.).
- Can you (the director) foresee solvency issues post 2020 (if so, consider pursuing the 2017 Safe Harbour as well).
Note that even if the COVID-19 safe harbour is used, criminal provisions will still apply against directors for breaches of the law.
Explanatory video on the safe harbour (2020)
In this brief video, Ben outlines what the safe harbour is, how it fits into the legislative framework and how to obtain the safe harbour protections. Please note this video was filmed before the COVID-19 temporary safe harbour’s operation was extended to 31 December 2020.
Interview about obtaining the safe harbour provisions (2018)
In this interview, Ben outlines the provisions implemented in September 2017, how they can be utilised, what they mean for phoenix activity and what the options are for directors.
- The September 2017 safe harbour provisions
- The prohibition on insolvent trading
- Implementing a plan
- The hurdles to obtaining the safe harbour provisions
- Phoenix activity
- Alternatives to the safe harbour provisions
- Changes to the safe harbour since 2018 (not including the temporary COVID-19 measures)
Podcast on the nature of the safe harbour provisions (2018)
Listen to Ben Sewell of Sewell & Kettle Lawyers in this podcast for Tax Talks from 2018 with Heide Robson discussing the safe harbour provisions.
In this podcast, Ben will explain the September 2017 safe harbour provisions and how they compare to international insolvency protections, the difficulties and implications associated with implementation and the role of professional advisers in the process.
- Summary of the September 2017 reform
- What is the prohibition on insolvent trading for company directors?
- Rules, but no specific process for the safe harbour mandated
- What is the “better outcome” test?
- This is not a Chapter 11 reform but a step towards it
- One size does not fit all
- Key hurdle is tax return lodgement and payment of employee entitlements
- Getting advice from an “appropriately qualified entity”
- What is a solicitor’s potential role?
- What is a turnaround plan?
Please click here to see Ben Sewell’s article on the safe harbour published in the Law Society Journal in April 2018.
What is the prohibition on insolvent trading?
Prior to 2017, the law effectively mandated directors to move to external administration as soon as their company was insolvent to avoid the risk of personal liability. Under section 588G of the Corporations Act, there is a prohibition on anyone who is appointed a director of a company in Australia from continuing to trade – that is, incurring debt – if the company is insolvent. Insolvency means that the company is not just experiencing a temporary liquidity problem but has an endemic shortage of working capital. The company is therefore unable to pay its debts as and when they fall due and payable. Section 588G is a cause of action that liquidators have against company directors after a company is placed in liquidation.
These reforms were a dramatic departure from the previous insolvency law because previously, a director of an insolvent company would be automatically advised to make a formal appointment. This was because under the prohibition against insolvent trading there was:
- a duty to creditors; and
- if the company went into liquidation, a potential liability to pay back a lot of the debts incurred while the company was trading whilst insolvent.
This has changed the game for professional advisors, lawyers and accountants because now there is a third path available: restructure through the safe harbour.
There is nothing specific in the legislation about the type of professional advisor required to advise the directors. This means that directors can also ‘self-help’. They can implement a plan to put themselves into a safe harbour.
The penalties for insolvent trading are:
- Civil penalties up to $200,000
- Liability to compensate the company or relevant creditors for the amount of debt incurred as a result of the breach
- Potential criminal prosecution
The duty to prevent insolvent trading does not apply when:
- At a particular time after the director suspects insolvency, the director starts to develop a course of action that is reasonably likely to lead to a better outcome for the company; and
- The debt is incurred in connection with the course of action.
An insolvent trading claim is like a lightning strike: they are rare, but they can be dangerous if you’re unlucky enough to receive one.
It is very unlikely that a director of an SME (up to 200 employees) would face an insolvent trading action. There are no statistics on how many demands have been issued by liquidators or what proportion of liquidations involve insolvent trading claims. However, one empirical study found that there were only 63 insolvent trading judgments in Australia between the 1960s and 2004. It is a demanding and expensive exercise for a liquidator to run an insolvent trading claim, so they are usually averse to this course of action.
When insolvent trading is a crime? Safe harbour exception
Insolvent trading is an offence under s 588G(3) of the Corporations Act, and in some cases, it may be referred to ASIC to pursue further investigation and possible criminal prosecution. In serious instances, it can incur a prison term. While civil proceedings are pursued first and more commonly to recover money, directors should be aware of the potential for insolvent trading to result in a criminal record. The safe harbour from insolvent trading will not protect directors from criminal liability. Note that for ASIC to pursue criminal charges, the insolvent trading will likely be serious and ongoing, perhaps accompanied by other wrongdoing. Civil insolvent trading claims are rare, and criminal insolvent trading proceedings are even more so.
ASIC often fails to pursue criminal charges due to a lack of evidence (given the high standard of proof), the cost of their time spent investigating the claim and preparing material for the prosecution, the cost of the DPP’s time spent in running the prosecution and the lack of incentive, especially for smaller companies (as the directors are usually personally bankrupt themselves).
Why is there no turnaround profession in Australia?
When comparing Australia to the US and UK, we lack a turnaround culture that supports businesses to restructure and resume trading after encountering financial difficulty. The structure of the US’ Chapter 11 Bankruptcy Scheme and the UK’s new voluntary administration process stand in stark contrast to Australian attitudes towards business failure; while the US and UK see failure as part of the business life cycle, Australians tend to be unforgiving and view restructure, whether formal or informal, to mean the death of a company. Linked to this culture is our lack of a turnaround profession. Incongruous and insufficient regulations and the prevalence of snake-oil advisors make it difficult for SMEs to locate quality pre-insolvency or turnaround advice; it can be hard to determine if a company needs a lawyer, an accountant, or something else entirely. For more information, read our article on pre-insolvency advisors.
Developing a plan
The Turnaround Management Association (TMA) lists six distinct stages in the turnaround process. Movement through these stages can be cited (or a documented plan to do so) may be used as evidence that the business has ‘developed a plan’ in line with the requirements for the safe harbour.
Stage 1 – Change in management
Some or all of the incumbent management are likely part of the issues the business is facing. In order to execute an effective turnaround, managers need perspective, credibility, knowledge and an open mind. During this stage, it is important to revitalise the management team where necessary in order to give a turnaround the best chance of ongoing success.
Stage 2 – Analysing the situation
This is the most important step in a turnaround and goes to the ‘developing a plan’ aspect required to gain protection through the safe harbour from insolvent trading. The business’ chances of survival must be identified, along with appropriate strategies that form a preliminary action plan.
Ask: is the company at an immediate risk of failure, or does it have substantial losses but its survival is not yet threatened? Alternatively, is there merely a declining business position?
There are three key requirements for viability: a sustainable core business, adequate financing and sufficient organisational resources.
Strengths and weaknesses should then be assessed throughout all areas of the business while the turnaround professional deals with the various stakeholders and keeps them up to date.
Once key issues are identified, a strategic plan with specific goals and detailed functional actions can be developed. This plan must then be ‘sold’ to all key parties within and surrounding the company in order to restore confidence.
Stage 3 – Emergency Action Plan
While a long-term plan is being developed, short term life saving actions must be performed. This can involve laying off employees, eliminating departments, cancelling product development and selling off stock. These difficult decisions should be made swiftly to prevent conjecture and stress.
Stage 4 – Restructure the business
Once short-term threats have been addressed, efforts are directed towards making the business efficient and sustainable. Restructuring must have the end goal of increasing profitability and returns on assets and equity. The people mix is important to manage at this stage.
At this stage, a business may use the safe harbour from insolvent trading in order to incur debts to facilitate the restructure.
Stage 5 – Return to normal
This stage focuses on a sustainable, controlled breath of relief. It is important not to return to bad habits, but to return to a state of maintenance for the future. The business may at this stage increase marketing, carefully explore options for increasing revenue, and shift their emphasis from cash flow to a strong balance sheet and strategic accounting and quality management systems.
A psychological shift here is important too, in order to rebuild momentum and morale after difficult times.
Stage 6 – Judging success or failure
This will look different for every business. Sometimes, success can be embodied in a fair sale to another entity or individual, or even in a graceful and value-securing liquidation, conducted efficiently and without undue conflict. For some businesses, it will mean a return to trade under different terms. What is most important is to reflect on how business practices can be improved in the future to avoid the requirement for a turnaround through better business planning.
Plan tactics: cost cutting and stabilisation
The safe harbour is essentially a short-term solution. So, any safe harbour plan must seek to achieve short term outcomes, which will then allow the company time to pursue long term options for a restructure. To distil the above, the two key attributes of any successful safe harbour plan must be cost cutting and achieving stabilisation. Costs must be cut in the short term to address solvency issues, as increasing sales are unlikely to occur during this time of volatility. This will likely involve firing staff; this should be done quickly rather than gradually, to see immediate returns and focus on rebuilding morale. Stabilisation should be the main goal of the plan before any transformative restructure is to occur. Stabilisation can involve reviewing management, suppliers and working capital so that they are on an even keel, providing the best possible foundation for a turnaround strategy later on.
Implementing a plan
In contrast to the US Chapter 11 requirements, in Australia directors do not need to go to court to get safe harbour protection at law. Section 588GA states that the safe harbour starts when the company director starts to implement a plan. Section 588GA provides that the plan does not need to be finally executed but directors will need some evidence of what they have done, for example a written plan or meeting minutes of what is being proposed.
To claim protection under the safe harbour, there is no requirement that a director actually execute a turnaround plan. The obligation upon a director is to start to “develop” a course (or courses) of action that is “reasonably likely to lead to a better outcome for the company.” The first consideration is that the onus is quite low, given that the alternative could involve the extinguishment of goodwill in a business and a fire sale of assets through a liquidation or voluntary administration. The second consideration is that the best outcome may be an ordinary liquidation or sale of assets and that while this is being undertaken, a director can legitimately claim the safe harbour. The key test to be considered is whether the course of action developed may be “reasonably likely to lead to a better outcome for the company.” A “better outcome” is compared to what would occur if there was to be an immediate appointment of a voluntary administrator or liquidator over the company. Critically, under the new safe harbour provision there is no penalty for directors utilising assets, while in the safe harbour that would have been available to satisfy creditor claims had a liquidator or voluntary administrator been appointed. One opponent of the safe harbour has also argued that it could shield directors while they undertake phoenix activity.
For the purposes of finding a course of action that is likely to lead to a better outcome for the company, regard is had to whether the director:
- Informs themselves about the company’s financial position
- Takes steps to prevent misconduct by officers or employees
- Keeps appropriate books and records
- Obtains advice from an appropriately qualified entity
- Develops or implements a plan for restructuring the company
Compared to the insolvent trading regime that it reforms the new safe harbour is designed to reward thoughtful company directors who make sensible records and document their actions.
Any ‘appropriately qualified’ entity, being a lawyer, accountant or a consultant is able to advise. The controversy in this is that the term is very vague and the uncertainty about whether the ‘appropriately qualified’ entity bears the risk if they do not provide accurate or appropriate advice to a director. For example, do lawyers provide that advice in their capacity as a lawyer or as a consultant? There is no requirement that it has to be in their capacity as a lawyer.
It is the role of an insolvency lawyer to consider:
- the personal risk to the directors;
- the structure of the business;
- whether there can be a restructure put in place; and
- working with other stakeholders.
If a company director is utilising the safe harbour provisions, there is no legal requirement that they inform their creditors. Disclosing that a company has put itself in a safe harbour position may result in their debts being called in by creditors.
The only company to disclose that they were in the safe harbour, was a mining company in 2018 and this was generally held by the industry to be a mistake as they had informed the ASX that they were in the safe harbour which was in turn made publicly available.
Qualifications of solicitors to be an “appropriately qualified entity”
One of the indicators of whether a director has a claim for safe harbour protection is whether they have obtained advice from an “appropriately qualified entity” (section 588GA(2)(d)). There isn’t much guidance on who this person may be but it certainly includes solicitors. The Explanatory Memorandum (Treasury Laws Amendment (2017 Enterprise Incentives No 2 Bill) explains:
1.35 The factors in subsection 588GA(2) therefore provide only a guide as to the steps a director may consider or take depending on the circumstances. For example, a small business may only need to seek the advice of an accountant, lawyer or another professional, while a large listed entity might retain an entire team of turnaround specialists, insolvency practitioners, and law and accounting firms to advise on a reasonable course of action.
The conclusion, certainly, is that an experienced solicitor may be an “appropriately qualified entity” to advise SME directors on safe harbour protection.
However, solicitors are not the only individuals qualified to assist SME directors on safe harbour protections and genuine turnaround effects. The TMA is the Australian chapter of a global organisation which is committed to promoting the benefits of legal restructuring to the economy. They have a diverse mix of members, including chief restructuring officers and turnaround practitioners, a host of professionals such as accountants, advisors, consultants and lawyers as well as financial advisors, lenders, investors and academics. TMA Australia members are actively engaged in financial and operational restructuring or provide ancillary professional advice. SME directors may be able to consult the TMA website and use their services to find an ‘appropriately qualified person’ suited to their business’ needs in utilising the safe harbour.
The same law, different behaviours: Large corporates versus SMEs
One criticism of corporate insolvency law in Australia is that the same law applies to large corporates (greater than 200 employees) and to small-to-medium sized enterprises (SMEs) (less than 200 employees) while the problems they face and their response to insolvency is significantly different. Large corporates have independent directors who don’t have their assets substantially tied up in the business and they have access to sophisticated professional advisers. On the other hand, SMEs are owned by their directors and are unlikely to have ready access to sophisticated professional advisers. SME directors have “skin in the game” and it is more than likely that their personal asset position is intrinsically linked to their company through personal guarantees.
The result is that SME directors are more likely than directors from large corporates to take a risk (both good and bad risk) when their company is facing insolvency. This is an important consideration for solicitors advising directors facing insolvency because a careful reading of section 588GA should be undertaken before advising a client about whether they have the right to claim the safe harbour. Directors of SMEs may be tempted to breach their duties when facing insolvency by undertaking phoenix activity (see ASIC v Somerville & Ors  NSWSC 934 for an example of a solicitor being found to have accessorial liability for phoenix activity).
Case study: Condor Blanco Mines’ disclosure to ASX
Condor Blanco Mines Limited was an Australian public company established in 2010. It was listed on the ASX in February 2011. A series of fraudulent management decisions led to Condor Blanco Mines being suspended from the ASX in 2016 for illegal share issues.
In November 2017, Condor Blanco Mines made an ASX announcement that they had adopted safe harbour status. Legally, you are not required to disclose that you are in the safe harbour to anyone – not even your bank or suppliers, let alone the ASX. Ultimately, Condor Blanco Mines was delisted in 2018, likely the result of a range of systemic issues within the company, but certainly not helped by their unnecessary disclosure.
Following the Condor Blanco Mines Disclosure, the ASX re-issued Guidance Note 08, clarifying that safe harbour status was exempted from continuous disclosure rules and that companies do not need to disclose to anyone that they are attempting a safe harbour restructure. The lesson from the Condor Blanco Mines case is to keep your cards close if you decide to utilise the safe harbour – it is essentially a provision which enables companies to buy time to restructure, and this is voided if everyone knows the company is in trouble.
Case study: why didn’t Virgin Airlines Australia use the safe harbour to restructure?
Virgin Australia called in voluntary administrators on 20 April 2020 after experiencing severe declines in business due to international travel restrictions put in place to halt the spread of COVID-19. Deloitte’s report revealed that the company was insolvent for a month before the voluntary administration was commenced. The business was ultimately sold to Bain Capital after around 8 weeks of voluntary administration.
It is difficult to determine exactly why Virgin did not make good use of the safe harbour provisions, but the likely answer is that they simply did not have enough time. Insolvency is a volatile spiral, and the more directors delay, the more money is lost. Even with the COVID-19 extensions to the Australian safe harbour provisions, they are relatively unforgiving when compared to the US’ Chapter 11 system which allows businesses six months to restructure. The uncertainty surrounding the pandemic in terms of its duration would have made it virtually impossible for Virgin to make accurate financial projections. Using the safe harbour would have eaten into cash at bank and wages for staff, without the support of creditors. There was no other way for Virgin to obtain the debt forgiveness needed without undergoing voluntary administration. Ultimately, it appears that given the climate of uncertainty, directors (potentially with skin in the game) decided that the best returns would be obtained through voluntary administration rather than a safe harbour restructure.
The hurdles to obtaining the safe harbour provisions
The main hurdles in section 588GA are:
(1) all employee entitlements of the company need to be paid as they fall due; and
(2) all of the company’s tax returns need to be filed.
In the small to medium-sized enterprise space, when a company is approaching insolvency they normally:
- stop preparing their tax returns;
- engage in creative accounting; and
- stop paying their superannuation or other employee entitlements.
If a company is not able to ensure that they are compliant, then they cannot take advantage of the safe harbour provisions. It is easier for large companies to comply with the hurdles because they have better processes and accounting support.
Phoenix activity is not safe harbour restructuring
There is no definition in the Corporations Act of what phoenix activity is and there are no specific prohibitions on it (other than creditor defeating disposition clawbacks).
One of the main characteristics of phoenix activity is that companies do not remit their PAYG tax to the Australian Tax Office. If you examine the affairs of a phoenix company, one of the issues is that the debts are left in one entity and the assets are transferred to another without any appropriate consideration being paid. This sort of activity may or may not mean that the company will fall short of one of the two hurdles in section 588GA.
These hurdles are an indirect way to try to stop the phoenix operators from engaging the safe harbour provisions. Another legal mechanism is the prohibition on creditor defeating dispositions.
Alternatives to the safe harbour provisions
The principle approach to deal with corporate insolvency since 1993 is to appoint a voluntary administrator. The safe harbour provisions have the potential to decimate the appointment of voluntary administrators in Australia and encourage sensible risk taking.
Over a long period of time, there has been a decline in the formal insolvency profession in Australia. This is because we have not had a recession and the banks have stopped making as many formal appointments. Now, if directors are able to put together a turnaround plan, they will not need to appoint one as long as they are complying with their employee entitlements, lodging their tax returns and implementing a plan which is likely to lead to a better return or can later be explained to a court.
Growth in the insolvency industry is largely restricted to the phoenix activity space and its prosecution.
There is a low chance that a director will be sued for insolvent trading, especially in a small to medium-sized enterprise. In fact, it has been said that “you have a greater chance in Australia of being bitten by a shark in George Street than being sued for insolvent trading”.
One empirical study, Insolvent Trading – an empirical study conducted by Paul James, Professor Ian Ramsay and Polat Siva found that there were only 63 insolvent trading judgments in Australia between the 1960s and 2004. For a liquidator to run an insolvent trading claim, it is a demanding and expensive exercise so they are usually averse to this course.
September 2017 Safe Harbour Summarised
- In summary, section 588GA says that if you are a director of a company and that company is insolvent (unable to pay its debts) if the director starts to put together a plan that has a chance of putting the company in a better position than it would have been compared to liquidation or voluntary administration, that plan can be implemented and the company turned around, the directors will not have to worry about the prohibition on insolvent trading.
- The reforms came about due to policy makers deciding that the previous prohibition on insolvent trading operated to discourage company directors from taking sensible risks when considering an informal workout as an alternative to voluntary administration.
- Some parts of the profession had wanted to make these new reforms a defence so that the liquidator could commence proceedings against a director. However, the new insolvency laws are not a defence to directors insolvent trading. Under the carve out reforms, the liquidators do not even have a claim.
- The reforms apply to both big and small companies. One of the characteristics of small-medium sized enterprises is that owners are often also directors whereas big enterprises will have independent directors.
- One of the disadvantages of these reforms is that there is a real risk that the plan will not be successful and that the turnaround will actually result in the asset value diminishing and not increasing. There is a real risk for creditors who may be put in a worse position by the safe harbour than if the company had immediately been put into liquidation or voluntary administration.
- There is, therefore, a risk to creditors and stakeholders with the implementation of these provisions as they are vague, laissez-faire and do not encourage sensible risk and may even encourage directors to take risks adverse to the creditors and stakeholders.
How does our system compare to Chapter 11 of the US Bankruptcy Code?
The foundation of the Australian insolvency regime, in contrast to chapter 11 of the US Bankruptcy Code, is that independent experts are appointed as liquidators, voluntary administrators or receivers to insolvent companies. Under Chapter 11, there is a debtor-in-possession regime where, with court approval, the managers of companies remain in control of the company while having the benefit of a moratorium from creditor action. The safe harbour is a step toward Chapter 11 because directors can continue to trade during insolvency while undertaking a restructuring process. However, unlike Chapter 11, there is no moratorium on the enforcement of creditor claims.
Note: the term ‘safe harbour’ as it is used in this article and in Australia is not used in the US in this way – in the US, ‘safe harbour’ provisions protect defendants from anti-avoidance suits.
How does our system compare to the UK and ‘wrongful trading’?
Wrongful trading is the UK equivalent to the prohibition on insolvent trading. It complements the concept of fraudulent trading, and requires no finding of ‘intent to defraud’, thus making it an easier burden to satisfy.
Wrongful trading is taken to occur when directors of a company continue to trade past a point when they knew or ought to have concluded that there was no reasonable prospect of avoiding insolvent liquidation, and did not take every step with a view to minimising the potential loss to the company’s creditors. A wrongful trading claim can only be brought by a liquidator once an insolvent liquidation has commenced. Wrongful trading claims can be brought against de jure, de facto and shadow directors.
In order to establish liability, the liquidator must show on the balance of probabilities that directors continued trading beyond a point when they knew or ought to have known that insolvent liquidation was inevitable.
However, it is not an offence to simply trade a company while it is insolvent. If the directors genuinely believe that the company and creditors’ position may improve, it is considered correct to trade while insolvent. This will become wrongful trading only when it should have been realised by directors that the position was likely to deteriorate and the company would proceed into liquidation.
UK law has a ‘blue sky’ defence which provides that if the directors, in good faith, believed that the company had good prospects of improvement, they will not be held liable for wrongful trading. Liability only attaches when the company has no realistic prospects of avoiding a liquidation. It is similar to the ‘business judgment rule’ defence to the director’s duty to provide care and diligence in s 180 of the Corporations Act in Australia in that it relies on good faith in determining the validity of a director’s actions. It is the UK’s answer to a ‘safe harbour’ but operates quite differently.
Capstone comment: Is a safe harbour restructure tactical for SMEs?
It is unlikely that a safe harbour restructure will be tactical for SMEs. Debts substantial enough to save a business will be difficult to obtain on decent terms if a business is insolvent and incurring further debts to existing suppliers will sour relationships and not address core business issues. A safe harbour restructure for SMEs may just increase the level of debt without fixing any of the root cause problems. SMEs should seek the advice of a professional adviser experienced in dealing with small businesses if they are insolvent or approaching insolvency.