What are the changes to the law?
The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (the new law) amends the Corporations Act 2001 (Cth) to create a ‘safe harbour’ for company directors from personal liability for insolvent trading if the company is undertaking a restructure outside formal insolvency.
The new law also changes the effect of ‘ipso facto’ clauses in contracts. An ipso facto clause is a clause in a contract that entitles a party to terminate a contract when certain circumstances arise, such as when one party enters into liquidation, regardless of the other terms of the contract and the continued performance by that party (in liquidation) of the contract. The new law makes ipso facto clauses unenforceable while a company is restructuring under certain formal insolvency processes.
Safe Harbour
Under the current law, section 588G of the Corporations Act 2001 (Cth) provides that if a person is a director of a company when the company incurs a debt, that company is insolvent (or becomes insolvent by incurring that debt), and there are reasonable grounds for suspecting that the company is insolvent at that time, then by failing to prevent the company from incurring that debt, the director is found to have contravened s588G(2) if:
- They are aware that there are such grounds for suspecting insolvency; or
- A reasonable person in a like position in a company in the company’s circumstances would be so aware.
Contravention of s588G(2) gives rise to personal liability and may give rise to a pecuniary penalty.
Amongst other provisions, the new law has introduced section 588GA in the Corporations Act 2001 (Cth), which creates a ‘safe harbour’ for directors to protect them from personal liability, and from the potential civil penalty exposure if section 588G(2) applies.
The safe harbour provisions, which commenced on 19 September 2017, will protect directors from personal liability for debts incurred by an insolvent company if, after a director ‘starts to suspect’ that the company may become or is insolvent, the director starts developing a course of action that is ‘reasonably likely to lead to a better outcome’ for the company than the immediate appointment of an administrator or liquidator. In order for the safe harbour to apply, the debt incurred by the company needs to be ‘directly or indirectly’ in connection with that course of action taken by the director.
Further, a director must do more than simply think about a problem. After starting to suspect insolvency, the new law sets out some factors that may be considered in determining whether the steps taken by the director were reasonably likely to lead to a better outcome for the company. This includes whether the director has sought advice from an ‘appropriately qualified’ entity, whether the director is properly informing himself or herself of the company’s financial position, and whether the director is ensuring that the company is keeping appropriate financial records. Directors seeking to rely on the safe harbour bear the evidentiary burden of demonstrating that they took the action necessary to lead to a better outcome for the company.
Directors may not be able to rely on the safe harbour if, at the time the debt is incurred, the company is not meeting its usual obligations, including payment of entitlements to its employees, and taxation reporting obligations.
Ipso Facto clauses
The new law puts a ‘stay’ on ipso facto clauses in contracts by preventing the enforcement of those clauses in certain circumstances, including when a company enters into administration or where the company is undertaking steps to avoid being wound up in insolvency. The period of the stay varies depending on the circumstances. For a company in administration, the period of the stay commences when a company comes under administration and ends when the administration ends.
By making ipso facto clauses unenforceable during a company’s restructure, financially distressed companies will have some ‘breathing space’ to continue to operate while they restructure and take steps to avoid becoming insolvent.
The stay on enforcement of the ipso facto clauses comes into force on 1 July 2018 and will only apply to contracts entered into after 1 July 2018.
What does this mean for directors?
Directors may breathe a sigh of relief to know that they now potentially have a safe harbour from which they can attempt to restructure a company in financial difficulty without being at risk of contravening section 588G(2) of the Corporations Act 2001 (Cth), rather than immediately appointing an administrator or a liquidator.
Directors should be mindful, however, that the safe harbour will not apply in circumstances where, when the debt is incurred, the company is not meeting its usual obligations such as paying employee entitlements and meeting taxation law reporting requirements. Directors must still continue to meet their other obligations including their directors’ duties.
What does this mean for insurers?
Insurers may need to consider whether relevant questions in proposals are wide enough to identify situations where, for example, directors have started to have concerns that a company may be insolvent, or where the directors are seeking advice on solvency.
The impact of the availability of the safe harbour on the conduct of directors and on the interests of creditors and company employees will be the subject of an independent review, two years after the commencement of the new law.
This article was written by Persia Navidi, Senior Associate and Jonathan Tapp, Partner.