Bankruptcy and insolvency law reforms and the innovation agenda

By Chris Prestwich
Government Restructuring & Insolvency Startups Technology

In brief

The Federal Government has released a Proposals Paper on possible changes to bankruptcy and insolvency laws that will form part of its broader National Innovation and Science Agenda. Reform to bankruptcy and insolvency law has been identified as an area that could contribute to changing 'the culture in our economy'. Partner Chris Prestwich, Managing Associate Valeska Bloch and Lawyer Tim Chiang look at the main aspects of the reforms. 

Supporting start-ups

The Proposals Paper provides more detail in relation to three areas of proposed reform:

  • Safe harbours: introducing a 'safe harbour' for directors, which would provide them with protection from possible insolvent trading claims while they seek to restructure a business;
  • Ipso facto clauses: preventing counterparties from exercising a contractual right to terminate that arises solely from an insolvency; and
  • Bankruptcy period: reducing the default bankruptcy period from three years to one year.

The measures are intended to strengthen Australia's start-up culture by moving away from a regime that focuses on penalising directors and stigmatising failure. Proponents hope that the new regime will encourage entrepreneurship and help start-ups attract experienced and talented board members.

'Safe harbour' for directors

Under current laws, directors who are working towards a restructure of a company that is in a distressed situation may be at risk of personal liability (and even criminal liability) for insolvent trading if the company subsequently fails and goes into liquidation. That risk is often the trigger for directors to appoint voluntary administrators, even if the company might be viable in the longer term.

The Proposals Paper contemplates two alternative 'safe harbour' solutions which are intended to give companies and directors greater flexibility to address liquidity issues outside the formal administration process:

  • The first (narrower) option is to provide directors with a defence against any insolvent trading claims subject to the satisfaction of certain applicable criteria, including the involvement of an appropriately qualified restructuring adviser.
  • The second (broader) option is for a complete carve out from the insolvent trading provisions provided that directors can satisfy three tests.

The Proposals Paper seeks input from the public on which of those options would provide an appropriate safe harbour. However, given the public policy rationale behind the insolvent trading provisions, in our view it appears more likely that the first option will be preferred.

Safe Harbour Model A

Under the first proposal, directors will have a defence to insolvent trading claims if a reasonable director would have had an expectation, based on advice provided by an appropriately experienced, qualified and informed restructuring adviser, that the company can be returned to solvency within a reasonable period of time, and the director has or is taking reasonable steps to ensure that it does so.

The defence will only apply if the restructuring adviser appointed is provided with appropriate books and records within a reasonable time from its appointment and remains of the opinion that the company can avoid insolvent liquidation and is likely to be returned to solvency within a reasonable period of time.

The proposed test is objective, based upon the expectations of the reasonable director. The defence would only be available if an appropriately qualified restructuring adviser had formed an opinion that the company is 'viable', meaning that it could avoid insolvent liquidation and be returned to solvency within a reasonable period of time.

The restructuring advisers would be appointed by the company and owe duties to the company, but would be expressly carved out of the definition of 'director' (ie they would not be at risk of being found to be a shadow or de facto director). They would have ongoing reporting obligations to ASIC in respect of any misconduct that they identify, and would be protected against third party claims in relation to their advice, provided their opinion was honestly and reasonably held. The restructuring adviser would also need leave of the court to be appointed in a subsequent external administration.

Certain directors will not be able to avail themselves of this defence, for example, if the director was disqualified from managing a corporation or if there had been a 'significant failure' to pay employee claims, PAYG, superannuation or employee claims that accrue during the safe harbour period.

Safe Harbour Model B

The second model operates as a complete exclusion to the insolvency trading provisions subject to the following three requirements:

  • the debt was incurred as part of reasonable steps to maintain or return the company to solvency within a reasonable period of time;
  • the director held the honest and reasonable belief that incurring the debt was in the best interests of the company and its creditors as a whole; and
  • incurring the debt does not materially increase the risk of serious loss to creditors.

This model incorporates both subjective and objective elements, would not require a restructuring adviser and would give directors considerable latitude to continue to trade in a distressed situation.

Making 'ipso facto' clauses unenforceable

Ipso facto clauses allow one party to terminate a contract upon the occurrence of certain events, such as the external administration of the counterparty. In some instances, termination of contracts on an insolvency can lead to a destruction in value and make it more difficult for receivers or administrators to trade the business as a going concern.

The proposed reform would prevent counterparties from terminating contracts on the sole basis that an 'insolvency event' has occurred. An 'insolvency event' would include an appointment of administrators, receivers or a scheme of arrangement or deed of company arrangement being entered into.

Counterparties would be given some protection under the proposed reform. Certain types of contracts would be excluded from this restriction, such as certain 'prescribed financial contracts'. The Government is seeking submissions as to the types of contracts that should be carved out. Counterparties would also be able to appeal to the court if they have suffered 'hardship'.

In a distressed situation, counterparties will often have other grounds on which they will be entitled to terminate the contract (eg non-payment), but in some scenarios, this reform could assist in preserving value.

The Proposals Paper also seeks submissions as to whether, in addition to preventing termination of contracts by reason of insolvency, the protection should be extended to prevent, for example, the acceleration of debts or triggering a requirement for the provision of additional collateral.

Reducing the default bankruptcy period

The current default period for a bankruptcy is three years, starting from the date on which the bankrupt filed his or her statement of affairs. It is proposed to reduce this to one year, on the basis that the three-year period may discourage innovation and business start-ups and a shorter period would encourage entrepreneurial behaviour and reduce the associated stigma of being a 'bankrupt'.

Under these proposals, the trustee would retain the ability to extend the bankruptcy to up to eight years. The Government is also considering a range of related proposals relating to ongoing obligations for bankrupts and restrictions that are applicable to bankrupts.

Reducing the bankruptcy period to 12 months will bring Australia into line with other jurisdictions. If the possibility of bankruptcy acts as less of a deterrent than it currently does, it remains to be seen if that will have a positive impact on entrepreneurial behaviour or if it will encourage risk taking by directors.