Allens

Insolvency & Restructuring

Focus: Government announces package of reforms to Australia's corporate insolvency laws

20 January 2010

In brief: The Federal Government's package of reforms to Australia's corporate insolvency laws, announced yesterday, proposes the adoption of additional mechanisms to encourage the reorganisation of companies in financial distress outside of external administration. The paper invites interested parties to make written submissions to the Treasury, which must be lodged by 2 March 2010. Partner Michael Quinlan and Lawyer Catherine Zahra report. 

How does it affect you?

  • In Australia, insolvent trading laws make directors personally liable for debts incurred while the company is insolvent. The laws are more draconian than those of other jurisdictions (which often require some element of fault or knowledge). They present a strong disincentive for informal work-outs, and are an area of considerable concern for directors of companies in financial difficulty. Many industry participants have expressed concern about the laws, particularly in the wake of the global financial crisis (the GFC). This is the first time that the Federal Government has responded to those concerns.
  • The paper proposes three possible options: maintain the status quo; adopt a modified business judgment rule; or adopt a mechanism for invoking a moratorium from the insolvent trading prohibition while work-outs are attempted. The proposed options seek to create a safe harbour for directors attempting a reorganisation of their company outside of external administration.

The discussion paper

The discussion paper, Insolvent Trading: A safe harbour for reorganisation attempts outside of external administration, provides an overview of Australia's current insolvent trading laws, and discusses the effects of insolvent trading on stakeholders and economic activity, and the options available to directors to address current or imminent insolvency of their companies. The paper discusses several important issues, including:

  • The impact of the GFC: The Government acknowledges that the reduction in credit availability in the wake of the GFC may have precluded some companies from attempting a work-out when faced with the personal liability of directors for insolvent trading, and that, while restrictions on credit have eased significantly, abnormal difficulties remain in obtaining funding. These impacts, it is suggested, may be responsible for a shift post-GFC away from arguments for the adoption of a broad general defence for insolvent trading, toward exploring a solution as to how the law impacts on informal work-outs.
  • Uncertainty as to the circumstances in which relief from liability might be granted to directors: The paper notes that the availability of discretionary relief from liability for insolvent trading under sections 1317S and 1318 of the Corporations Act 2001 (Cth) is uncertain – the provisions contain no criteria to be used by the court in determining whether to exercise its discretion and there is little case law as to the operation of the provisions in respect to insolvent trading.
  • Getting the balance right: Among the policy justifications noted for the prohibition against insolvent trading, the paper suggests that the prohibition provides an assurance to those transacting with any company that the company is solvent and can meet its debt obligations. Reducing the threshold for director liability, and/or increasing the risk of abuse of insolvent trading laws, may decrease the level of confidence that market participants are solvent, leading to negative impacts on the perception of counter-party risk, the willingness to provide credit, the cost of credit, and the conditions upon which credit is provided. On the other hand, the paper acknowledges concerns raised by stakeholders that the insolvent trading laws may cause companies to be placed into external administration prematurely or in circumstances where external administration is not appropriate.

The paper proposes three possible options for reform:

  • Maintain the status quo: Reasons for retaining the law as it now applies include the potential consequences of any weakening of the prohibition against insolvent trading and the possibility that any safe harbour from liability for insolvent trading might be the subject of abuse.
  • A business judgment rule for insolvent trading: The paper considers the introduction of a general defence, equivalent to the 'business judgment rule', which would extend to insolvent trading. The business judgment rule currently operates as a defence to breach of the statutory duty of care and diligence in s180 of the Corporations Act.

Under this option, directors will be relieved of the duty not to trade while insolvent if the following elements are satisfied:

  • the financial accounts and records of the company present a true and fair picture of the company's financial circumstances at the time that the rule was invoked;
  • the director was informed by restructuring advice from an appropriately experienced and qualified professional with access to those accounts and records, as to the feasibility of, and means for, ensuring that the company remains solvent, or that it is returned to a state of solvency within a reasonable period of time;
  • it was the director's business judgment that the interests of the company's body of creditors as a whole, as well as members, were best served by pursuing restructuring; and
  • the restructuring was diligently pursued by the director.
  • Moratorium: The final option is the adoption of a mechanism for invoking a moratorium from the prohibition against insolvent trading while work-outs are attempted. This would require the company to inform the market that the company was insolvent and intended to pursue a work-out outside of external administration. Limits may be placed upon the periods during which a company is permitted to trade while insolvent. Creditors may play a role in determining whether the moratorium should continue or whether to deal with the company while insolvent.

The discussion paper does not seek to resolve some of the difficulties around assessing insolvency. For example, there is no attempt to simplify the meaning of insolvency or clarify issues such as how far into the future a director must look in assessing a company's present solvency.1 The paper limits its attention to considering additional mechanisms to enable turnarounds while reducing the potential for directors to be exposed to insolvent trading.

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Other reforms

The reform package announced by the Federal Government will also amend the Corporations Act to reverse the effect of the High Court's decision in Sons of Gwalia v Margaretic (2007) 231 CLR 1602and implement reforms directed at reducing the costs and complexity of insolvency administrations, improving communications with creditors and reducing the potential for abuse of corporate insolvency law.

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Conclusion

The reforms, if adopted, (particularly the business judgment exception) would be a significant milestone in the reform of Australia's insolvent trading regime. The paper addresses many of the concerns raised by industry participants and stakeholder groups following the GFC. The proposed reforms will better align Australia's insolvent trading regime with developments in other countries directed toward minimising the impact of the GFC,3 though the main thrust of the laws will still be more strict than overseas equivalents. Significantly, however, the proposed reforms are intended to be permanent. The legislature has not chosen to adopt temporary measures of relief, such as those in Germany, where amendments to the Insolvency Code relaxing the requirement to file for insolvency are due to expire in December 2013.

The discussion paper provides an important opportunity to comment on the proposals for reform to the insolvent trading laws. Comments are due by 2 March 2010.

Past papers presented at Allens Arthur Robinson Corporate Insolvency & Restructuring Forums, the Annual Reviews of Insolvency & Restructuring Law, and Focus articles are available at www.aar.com.au

Footnotes
  1. Allens Arthur Robinson, Focus: Guidance for directors on duty to prevent insolvent trading, 25 November 2009.
  2. Allens Arthur Robinson, Shareholders can rank with creditors – the Sons of Gwalia High Court decision, February 2007. Allens Arthur Robinson Partner Diccon Loxton spoke to Boardroom Radio on 19 January 2010 about what the Federal Government needs to do to reverse the Sons of Gwalia decision and what effect such a move will have on insolvency laws in Australia. To hear Diccon's interview, go to http://www.aar.com.au/med/audio.htm. 
  3. Allens Arthur Robinson, Latest Developments in Insolvent Trading, 27 May 2009.

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