Safe harbour for directors’ duty to prevent insolvent trading gains momentum

In April 2016, the Government released a Proposal Paper¹ seeking feedback on, amongst other things, two alternate proposals for implementing a ‘safe harbour’ for directors in respect of their statutory duty to prevent insolvent trading under section 588G of the Corporations Act 2001 (Cth) (Act). The Proposals Paper was released as part of the Government’s National Innovation and Science Agenda, and expressed the aim of the ‘safe harbour’ as being to preserve enterprise value and foster directors taking appropriate business risk.

Late last month, almost one year after the Proposals Paper, the Government released an Exposure Draft² of legislation amending the Act in two key respects:

• firstly, creating a ‘safe harbour’ for directors in respect of their statutory duty to prevent insolvent trading under section 588G of the Act in certain circumstances; and
• secondly, rendering ‘ipso facto’ clauses unenforceable if a company has entered into a formal insolvency process.

While restrictions on the enforceability of ipso facto clauses is a welcome reform, this article will focus on considering the broad concepts underpinning the proposed safe harbour.

What is being proposed?

If enacted, a new section 588GA will operate as a carve-out to the directors’ duty to prevent insolvent trading. That is, the duty to prevent insolvent trading will not apply in relation to a person provided two elements are satisfied:

• after suspecting existing or impending insolvency, the person starts to take a course of action that is reasonably likely to lead to a better outcome for the company and the company’s creditors; and
• the debt is incurred during a particular period of time, which is expressed as starting when the person begins to take the course of action and ending when either (1) the person ceases to take the course of action; (2) the course of action ceases to be reasonably likely to lead to a better outcome for the company and its creditors; or (3) when the company becomes a Chapter 5 body corporate,³ whichever is earlier.

Proposed section 588GA(2) sets out a number of matters to be considered in determining whether a course of action is “reasonably likely to lead to a better outcome for the company and the company’s creditors”. These are largely designed to balance the aims of the draft legislation with the interests of other stakeholders, by limiting availability of the ‘safe harbour’ to honest and diligent directors.⁴

Accordingly, in order to avail himself or herself of the ‘safe harbour’ regard will be had to whether the director:

• is taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to repay its debts;
• is taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company;
• is obtaining appropriate advice from an appropriately qualified entity who was given sufficient information to give appropriate advice;
• is properly informing himself or herself of the company’s financial position; and
• is developing or implementing a plan for restructuring the company to improve its financial position.

The above list is not exhaustive and so a court has sufficient latitude to consider other matters in determining whether the course of action taken by the director was reasonably likely to lead to a better outcome for the company and the company’s creditors.

Section 588GA(3) also clarifies that it is the impugned director who bears the onus of proving that the safe harbour applies. Where the company ultimately becomes a Chapter 5 body corporate, any books or information that the director has withheld from the administrator or liquidator following a reasonable request may not be used by the director as evidence in establishing the safe harbour.

Further, the safe harbour will not be available if the company has not provided for employee entitlements or given the notices and other documents required by taxation laws, ‘to a standard that would reasonably be expected of a company that is not at risk of being wound up in insolvency’.

Lavan comment

The concepts created by the draft legislation rely heavily on the test of reasonableness and the assessment of alternate outcomes. Therefore it seems that, if enacted, the changes will prompt the development of a large body of case law regarding the interpretation and application of these concepts. This is particularly in circumstances where the operation of the safe harbour stands between an external administrator and a successful claim on a director’s D&O policy.

What is meant by a ‘better outcome’ for the company and its creditors?

The course of action taken by the director has to be reasonably likely to lead to a better outcome for the company and its creditors. The Exposure Draft defines the term ‘better outcome’ as an outcome that is better for both the company, and its creditors as a whole, than the outcome of the company being a Chapter 5 body corporate.

However, the criteria by which an outcome is assessed to be ‘better’ is unclear. Difficulties are likely to arise in assessing contingent or non-monetary outcomes that may still be of value to creditors. For example, the restructuring of the company may be preferable for a trade creditor by preserving the prospect of future business, but it may also require that creditor to compromise their existing debt for an amount less than they would receive in a liquidation scenario. Therefore, while a winding up may produce a better financial outcome in respect of the current debt owed, the prospective financial benefit contingent upon future supply contracts may be of greater overall value to the creditor in the long run. In that scenario, which is the ‘better outcome’?

Objective reasonableness

The requirement that the course of action taken by the director be ‘reasonably likely’ to lead to whatever is assessed as the ‘better outcome’ is designed to exclude directors ‘whose recovery plans are fanciful’⁵ from the protection of the safe harbour.

The Explanatory Memorandum states that the test of reasonableness is an objective one.⁶ Therefore the subjective belief of the director as to the reasonableness of his or her course of action is irrelevant.

Duration of the protection

Under the draft legislation, the protection afforded by the safe harbour will run from the time the director starts taking the course of action discussed above, until the first of the following occurs:

• the director ceases taking that course of action;
• the course of action ceases to be reasonably likely to lead to a better outcome for the company and its creditors; or
• the company becomes a chapter 5 body corporate.

Directors must therefore be constantly alive to the ongoing viability of the course of action they are undertaking and this reflects the intention that the safe harbour should not be used as a mechanism for a company to continue to trade past the point where it is viable.⁷

Interest of creditors

If enacted, the safe harbour will require the interests of creditors to be front and centre of a director’s mind when attempting to restructure a company. Although this does not create a separate duty owing to (and actionable by) creditors per se, it does reinforce the requirement for directors to consider the interests of creditors as a company approaches insolvency. This requirement already exists at common law as part of the bona fide rule which underpins the directors’ duty to act in good faith in the interests of the company.⁸