INSIGHT

Two safe harbours for the storm of COVID-19

By Tania Cini, Matthew Whittle, Stephen Hurford

In brief

COVID-19 is causing upheaval around the world and is disrupting businesses, regardless of their size, industry or fundamental viability.

Many companies and directors are for the first time having to consider the operation of the insolvent trading provisions of the Corporations Act 2001, including the 'safe harbour' provisions introduced in September 2017 (2017 Safe Harbour).

On 22 March 2020, the Federal Government announced further amendments to the Act designed to provide further relief for financially stressed businesses, including an additional 'safe harbour' from insolvent trading liability in respect of debts incurred during the next six months 'in the ordinary course of the company's business' (COVID Safe Harbour). The COVID Safe Harbour amendments were rapidly passed by Parliament on 23 March 2020.

The COVID Safe Harbour will provide useful additional relief for companies and their directors, particularly those grappling with an unprecedented change to their business conditions and who need time to assess the company's position before developing a turnaround plan or pursuing an insolvency administration.

However, for many businesses, the latest reforms will not be enough on their own – a detailed and documented survival and turnaround plan will still need to be prepared and implemented to assist the company through COVID-19 and to protect its directors from insolvent trading liability (and breach of general directors' duties) during the next six months and beyond.

Key takeaways

  • COVID-19 and the responses to it from governments both in Australia and worldwide have had an immediate impact on business, putting many companies at risk of trading while insolvent or being forced to cease operations due to short-term liquidity issues.
  • In response, the Federal Government has introduced a new insolvent trading 'safe harbour' comprising a six-month moratorium on insolvent trading liability in respect of debts incurred 'in the ordinary course of the company's business' (ie the COVID Safe Harbour). The Government has also increased the minimum debt which can form the basis for a statutory demand (from $2,000 to $20,000) and the period within which the debt must be paid (from 21 days to 6 months).
  • The new COVID Safe Harbour will provide useful immediate relief for companies and their directors, particularly those who need time to assess the company's position before developing a turnaround plan or pursuing an insolvency administration if that becomes necessary.
  • For some businesses, it is possible that the new COVID Safe Harbour may provide directors with sufficient temporary protection from insolvent trading liability, particularly if their company is expected to recover quickly following the passing of the COVID-19 crisis and be in a position to pay its outstanding debts. However, the directors would need to satisfy themselves as to the scope of the safe harbour protection and the ability to return to solvent trading once the six-month period ends.
  • For most businesses in financial distress as a result of the COVID-19 crisis, the new COVID Safe Harbour will not be enough on its own to protect directors from the risk of future insolvent trading liability (or their companies from insolvency). It is likely the impact of COVID-19 will continue for more than six months, either as a result of ongoing business restrictions or ongoing fallout from the crisis - it will not simply be a case of the company 'hibernating' for six months and then returning to solvent trading. Instead, more significant steps will be needed to manage existing creditors and restructure the business for survival.
  • It is also important to bear in mind that general directors' duties still apply, so directors must continue to actively engage in identifying and dealing with the issues that confront the businesses they lead and the impact those issues are having on their creditors. Documenting and implementing stabilisation and survival plans to address those issues will be critical. Where those plans become unrealistic or unworkable, consideration should still be given to external administration options and the additional protections that might be afforded through those regimes.
  • As a result, most businesses will still need to work quickly to prepare a detailed survival and turnaround plan that will encompass some or all of the well-established techniques used by insolvency professionals, such as refinancing, capital raising, creditor standstills, rapid cost reductions, business restructures and more. They will also need to monitor the implementation of the turnaround plan and ensure it is updated and revisited as the COVID-19 crisis evolves.
  • In these circumstances, it would make sense for businesses to prepare a plan which meets many of the requirements of the existing 2017 Safe Harbour' provisions. The COVID Safe Harbour nevertheless still has a part to play. It will give directors some breathing space to work through these issues in an orderly way and the time to take advice and prepare and implement a plan that potentially provides more fulsome and long-lasting protection under the 2017 Safe Harbour.

Who in your organisation needs to know about this?

Company directors and the company's legal, risk and compliance teams need to be aware of the existing and new safe harbour provisions and the requirements that must be met for a safe harbour plan to be effective.

Temporary relief for businesses in financial distress

On 22 March 2020, the Federal Government announced certain amendments to the Corporations Act 2001 (the Corporations Act) designed to assist businesses in financial distress as part of the economic measures it is taking to meet the COVID-19 crisis. Those measures included temporary relief for directors from their duty to prevent insolvent trading and a temporary increase in the minimum amount and time period for statutory demands.

On 23 March 2020, Federal Parliament rapidly passed the Coronavirus Economic Response Package Omnibus Bill 2020 (the COVID Act) to implement these and other measures.

Temporary relief from insolvent trading liability

The COVID Act inserts a new section 588GAAA into the Corporations Act titled 'Safe harbour—temporary relief in response to the coronavirus'. That section provides that a director will not be liable for insolvent trading in respect of a debt incurred:

  1. in the ordinary course of the company’s business; and
  2. during the six-month period starting on the day the section commences (or any longer period prescribed by the regulations).

It is not clear which debts will be regarded as being incurred 'in the ordinary course of business', particularly in these extraordinary circumstances, and the evidential burden will fall upon the directors to show that the debt was so incurred (s 588GAAA(2)).

The phrase 'in the ordinary course of business' is used in a variety of statutory contexts (including the Bankruptcy Act, Corporations Act and PPSA) and has received judicial consideration over many years, however there is no consistent view on the meaning of the phrase. It might be argued that a debt cannot be incurred in the ordinary course of business when the company is otherwise insolvent, however such an interpretation would undermine the very purpose of the section.

Paragraph 12.18 of the Explanatory Memorandum for the COVID Act says that a director 'is taken to incur a debt in the ordinary course of business if it is necessary to facilitate the continuation of the business during the six month period that begins on commencement of the subparagraph. This could include, for example, a director taking out a loan to move some business operations online. It could also include debts incurred through continuing to pay employees during the Coronavirus pandemic.'

This suggests that the safe harbour is intended to apply not only to debts incurred as part of the ordinary day-to-day trading operations of the business (eg usual trade creditors, employee expenses, fixed costs etc), but possibly also to debts incurred to restructure a business to enable trading through this specific COVID-19 crisis (such as new working capital loans, ramping up online operations, delivery services etc). If that is the Government's intent, the term 'ordinary course of business' should be interpreted as including debts incurred in good faith which are aimed at keeping the business going, even if they are exceptional in nature.  

it would make sense for businesses to prepare a plan which meets the requirements of the existing 2017 Safe Harbour and which extend beyond the next six months.

However, it may become increasingly hard to categorise debts as being incurred in the ordinary course of business if, during the six month period, it becomes increasingly clear that the company will not be able to pay its debts at the end of that period and there is no detailed plan in place for the solvent continuation of the business after the six-month relief period. For this reason also it would make sense for businesses to prepare a plan which meets the requirements of the existing 2017 Safe Harbour and which extend beyond the next six months.

We expect more clarification will be required on these points. The Government has contemplated a mechanism for further clarification regarding the scope of the safe harbour protection through the passing of regulations. The new section 588GAAA(3) states that the safe harbour 'is taken never to have applied in relation to a person and a debt in the circumstances prescribed by the regulations for the purposes of this subsection'. No draft regulations had been released at the time of publishing this article.

Amendments to statutory demands

The COVID Act also amends the Corporations Act and Regulations such that for the next six months:

  1. the minimum debt which can form the basis for serving a statutory demand on a company has increased from $2,000 to $20,000; and
  2. the period within which a company must pay the amount demanded (or make an application to set aside the demand) has increased from 21 days to six months.

These amendments will help provide companies with some breathing space so that they can deal with their financial issues without the immediate threat and distraction of winding up proceedings being commenced by creditors. While the debt threshold of $20,000 is still not particularly high (especially for large businesses), the extension of the time to respond is more significant.

Are these provisions enough?

Will the new provisions provide directors with sufficient ongoing protection from insolvent trading liability and their businesses with sufficient protection from insolvency during the COVID-19 crisis? For many companies and directors, we think the answer is no.

Certainly, the new COVID Safe Harbour will provide some welcome immediate relief for company directors who need time to assess the company's position before developing a survival and turnaround plan or pursuing an insolvency administration. The provisions may help to avoid directors immediately placing their companies into administration or liquidation while they assess their options and take appropriate advice. This is a worthy outcome of the COVID Act in itself.

In addition, for some businesses, it is possible the new COVID Safe Harbour may provide directors with sufficient protection from insolvent trading liability, particularly if their company is expected to recover quickly following the passing of the COVID-19 crisis and be in a position to pay its outstanding debts. However, the directors would need to be satisfied that:

  1. any debts the company intends to incur during the six-month period will fall within the scope of the safe harbour (eg the 'ordinary course of business' requirement and any associated regulations that are released); and
  2. the company will be able to return to solvent trading at the end of the six-month period.

For many businesses in financial distress as a result of the COVID-19 crisis, it will be very hard to meet the return to solvent trading criterion. It is likely the impact of COVID-19 will continue for more than six months, either as a result of ongoing business restrictions or simply ongoing fallout from the crisis which may have depleted the company's cash reserves, increased its finance costs and impacted its market and supply chains for an extended period. Particularly for large companies, it will not simply be a case of the company 'hibernating' for six month and then returning to solvent trading. Instead, more significant steps will be needed to manage existing creditors and restructure the business for survival.

It is also important to bear in mind that general directors' duties still apply, so directors must continue to actively engage in identifying and dealing with the issues that confront the businesses they lead and the impact those issues are having on their creditors. Documenting and implementing stabilisation and survival plans to address those issues will be critical. Where those plans become unrealistic or unworkable, consideration should still be given to external administration options and the additional protections that might be afforded through those regimes.

As a result, most business will still need to work quickly to prepare a detailed plan that will encompass some or all of the well-established techniques used by insolvency professionals, such as refinancing, capital raising, creditor standstills, rapid cost reductions, business restructures and more. They will also need to monitor the implementation of the plan and ensure it is updated and revisited as the COVID-19 crisis evolves. In these circumstances, it would make sense for businesses to prepare a plan which meets many of the requirements of the existing 2017 Safe Harbour.

How does the 2017 Safe Harbour Work?

In September 2017, new 'safe harbour' provisions were introduced to the Corporations Act which are intended to provide directors with protection from insolvent trading liability while they are pursuing a turnaround plan.

The 'safe harbour' applies where a director, after beginning to suspect a company may become or be insolvent, starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator. Debts incurred 'directly or indirectly in connection with that course of action' are excluded from the directors' liability for insolvent trading under the Act.

Preparing a safe harbour plan

To obtain the benefit of the 2017 Safe Harbour provisions, directors must be able to demonstrate that the course of action adopted by the company is reasonably likely to lead to a better outcome than the immediate appointment of an administrator or liquidator. To do this, directors should ensure the intended course of action is in the form of a written plan.

The safe harbour plan should:

  • contain details of the company's current financial situation to demonstrate that the directors had properly informed themselves in this regard;
  • contain a sufficient level of detail about the intended course of action, including measures for the ongoing assessment of the course of action;
  • compare the outcome to the company and its employees, shareholders and creditors of the successful implementation of the intended course of action against the outcome in an external administration scenario;
  • ideally be supported by legal and accounting advice.

The exclusions from liability for insolvent trading apply only while the intended course of action is being pursued. It is therefore in the interest of directors to move to implement a safe harbour plan as soon as they identify that the company may be or may become insolvent. That said, the COVID Safe Harbour will provide some breathing space in this regard.

Ongoing assessment of the plan is required

Under the Act, the 2017 Safe Harbour protections apply until:

  • the directors or the company stop taking the course of action;
  • the course of action stops being reasonably likely to lead to a better outcome; or
  • the company goes into administration or liquidation.

As such, it is not sufficient for directors to only prepare a safe harbour plan. Directors are required to assess the plan on an ongoing basis to determine whether pursuing the intended course of action will continue to lead to a better outcome than the appointment of an administrator or liquidator. This may necessitate altering the course of action, or potentially appointing an administrator or liquidator if a better outcome is no longer possible.