Insolvency reforms on the radar
On 28 March 2017, the Federal Government announced that it will introduce insolvency reforms aimed at empowering companies to restructure when insolvent without going into administration or liquidation. These reforms will affect liquidators, professional advisers, companies approaching insolvency, and the businesses (especially financiers and landlords) that trade with them. The first proposal is to allow company directors to trade while insolvent, provided they are taking all reasonable steps to restructure their companies. The second proposal is to void any agreements that allow a party to terminate a contract if the other party to that contract becomes insolvent (also called “ipso facto” clauses). Both reforms could have far-reaching consequences for businesses and the economy. This article focuses on the safe harbour reforms.
What can an insolvent company or its creditors do now?
Currently, a company facing the prospect of insolvency has three choices: (1) continuing to carry on business, (2) voluntary administration or (3) involuntary liquidation by the creditors. These are summarised below.
Continued operations. Continuing to carry on business comes at a significant risk to the company’s board of directors. By law,[1] directors become personally liable for their company’s debts and are exposed to civil (or even criminal) penalties if they fail to take reasonable steps to ensure that the company remains solvent.
Administration. A company under administration is placed under the control of a registered liquidator—essentially a very specialised and experienced accountant. Importantly, voluntary administration offers companies a temporary safe harbour from their creditors. Creditors generally cannot sue a company that is undergoing liquidation for a debt, and current litigation may be stayed pending the outcome of the administration process. This allows administrators a short period in which to assess whether to restructure the business, renegotiate its debts and return it to profitable operations. If this is impossible, the administrator may put the company into liquidation.
Liquidation. If a company is proven to be insolvent, its creditors or administrator may put it into liquidation and appoint a registered liquidator who becomes responsible for the company’s operations. Similarly to a company under administration, a company under liquidation enjoys a ‘safe harbour’ from litigation by creditors. However, the liquidator’s role is different. The liquidator must act to ensure that the best possible value is attained for creditors. If a liquidator believes that creditors will recover more through an asset sale than by turning the company around or selling it as a going concern, the liquidator must conduct the asset sale. A liquidator must also carefully review the company’s books to ensure that the directors have not breached their duties by acting negligently, fraudulently or traded while insolvent. In such cases they may need to take legal action against the board or individual directors to recover funds for the creditors.
The Reforms
The proposed reforms offer an alternative for directors seeking to continue their company’s operations. According to the exposure draft of the legislation, directors will not be liable for insolvent trading when they incur debts ‘in connection’ with a ‘course of action that is reasonably likely to lead to a better outcome for the company and the company’s creditors.’ If done right, this director-led restructure could avoid the significant costs and legal risks for creditors and directors in the administration and liquidation process.
Under the draft legislation, it will be up to the directors to prove that their course of action is ‘reasonably likely to lead to a better outcome.’ To do so, directors will need to draft a restructure plan, obtain financial or legal advice and review the company’s financial position. Companies must also still provide for their employees’ entitlements (such as superannuation) and comply with taxation laws. Above all, directors must assess whether their plan will render the company profitable. If not, the safest option will be to put the company into administration.
Administration and insolvency are complex areas of law that require careful consideration for directors, administrators and liquidators alike. Should you have any further questions about the current law or the proposed reforms, contact us.
Contact Legal Enablers: Caroline Mense, Principal Lawyer Phone: (03) 8691 3128 Email: carolinem@legalenablers
[1] See s588G-s588H, Corporations Act 2001 (Cth).