Safe Harbour Provisions and Insolvent Trading

By Isabel Coulton

In the corporate world, a Director’s duty to prevent insolvent trading is a fundamental obligation which, due to the personal liability attaching to any breach of such obligation, has policy makers and Regulators wary of a culture of companies being placed into liquidation prematurely. Essentially, the strict liability under the Corporations Act (Cth) 2001, which is considered to invoke one of the harshest insolvent trading regimes in the world, has seen to be acting as a disincentive to corporate restructuring – as companies were alternatively being placed into premature wind-up.

Directors, particularly those of mid to large entities with ‘no skin in the game,’ were seen to be generally unwilling to take the risk of continuing to trade during financially difficult periods. Ostensibly, why risk any personal liability of any subsequent insolvent trading claim involved with the company continuing to trade through financial insecurity and any associated attempted restructure, when you can take your pay cheque and run – reputation largely still intact.

Of further concern to policy makers and Regulators, Directors of SMEs who, unlike their counterparts of larger corporate entities, had significant ‘skin in the game’, were generally taking a different approach to avoid any potential personal liability under the insolvent trading regime.  Liquidation of a company does not preserve any goodwill value. As such, Directors of these smaller entities were minded to engage in practices of illegal phoenix activity. This involves the creation of a new corporate entity – stripping any assets (including goodwill) from the old entity and transferring to the new entity – resulting in the old entity shell of liabilities being placed into liquidation. Whilst illegal, this activity is incredibly difficult for Regulators to monitor and track. Additionally, any subsequently appointed Liquidator is unlikely to pursue such illegal activity further, in circumstances where the Liquidator is largely unfunded.

In the circumstances, the Act has been amended to include a new section 588GA which provides a “safe harbour” with regards to a director’s duty to prevent insolvent trading. Ostensibly, the duty to prevent insolvent trading does not apply when:

“at a particular time after the director suspects insolvency the director develops a course of action that is reasonably likely to lead to a better outcome of the company, and the debt is incurred in connection with the course of action.”

Unfortunately, the legislatures have managed to draft the new carve-out to be incredibly vague and lacking in any substantive detail. For the purposes of determining whether a course of action is “likely to lead to a better outcome for the company”, regard is had as to whether the director:

1. informs themselves about the company’s financial position;
2. takes steps to prevent misconduct by officers or employees;
3. keep appropriate books and records;
4. obtains advice from an appropriately qualified entity;
5. develops or implements a plan for restructuring of the company.

Importantly however, the Act does identify certain elements that must be satisfied before Directors can claim the protections of the new safe harbour provisions:

1. the company must pay entitlements of employees by the time they fall due. Arguably however, this includes Director’s wages, which could be problematic for many SMEs whose Directors forego wages; and
2. tax returns of the company are to be filed (but not paid).

The safe harbour provisions are taken to cease to apply to a Director when:

1. the Director fails to take action within a reasonable time;
2. the Director ceases to take the course of action;
3. the course of action cases to be reasonably likely to lead to a better outcome for the company;
4. a Voluntary Administrator is appointed;
5. the Director doesn’t co-operate with a subsequently appointed Liquidator (protection lost retrospectively).

Given the infancy of the safe harbour provisions, as yet there is no case law or guidance from the Courts with regard to the application, operation or interpretation of these new provisions. However, one can expect that this is only a matter of time.

In relation to these new provisions achieving the cultural restructuring shift intended by the legislatures and Regulators, this is yet to be seen. However, given that the premise of the desired corporate restructure is based on the assumption that the relevant officeholders want to actually try and ‘save’ a company that is presumably severely debt laden, one would be forgiven for being sceptical as to the future practical success of these amendments.