Australia’s current insolvent trading laws and lack of protection against “ipso facto” clauses can make certain restructurings and workouts far more difficult than they need to be. Reform is necessary to ensure Australian businesses maintain a commercial edge in a fast-changing economy affected by digital and other disruption.

This article examines the proposed changes contained in the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Bill 2017 (Cth) which, at the time of publication, is before the Senate. It also provides some practical guidance for directors facing financial difficulties.

Corporate insolvency in Australia

Australia’s current insolvent trading laws mean directors (including non-executive directors) face personal liability when their company is in severe financial difficulties and they are confronted with a necessary financial restructure. In recent years there has been a dramatic increase in restructures undertaken by restructuring and turnaround professionals in Australia drawing upon experiences in the US and UK: for instance Alinta Ltd and McColl’s Transport.

Currently a director must prevent their company from incurring debts where the company is insolvent or becomes insolvent by incurring the debt, and at that time there are reasonable grounds for suspecting the company is insolvent, or would become insolvent. Failing to guard against insolvent trading may result in the director being personally liable for debts incurred while the company was insolvent.

A new regime on the way

Recently, the federal government introduced the Bill into parliament which proposes to:

• create protection (a safe harbour) for company directors involved in restructuring a business by protecting them from personal liability for insolvent trading claims under certain conditions; and
• make ipso facto clauses unenforceable in certain circumstances.

A “safe harbour” from insolvent trading

In short, if directors take appropriate steps such as obtaining expert advice and preparing a restructure plan that is reasonably likely to lead to a better outcome than an insolvency appointment, they can protect themselves from liability for insolvent trading.

Under the proposed reforms, directors will enjoy protection (a safe harbour) if they take a course of action that is reasonably likely to lead to a better outcome for the company and the company’s creditors as a whole than proceeding to immediate administration or liquidation. The inclusion of certain conditions (eg, the need to maintain books and records and pay employee entitlements as they fall due) should help guard against abuse of the provisions.

In determining whether a course of action is reasonably likely to lead to a better outcome for a company and its creditors, the following actions by directors may be considered:

• taking appropriate steps to prevent misconduct by officers or employees;
• obtaining appropriate advice from a suitably qualified adviser who was given sufficient information to give appropriate advice;
• taking appropriate steps to ensure the company is keeping appropriate financial records;
• properly informing themselves of the company’s financial position; and
• developing or implementing a restructuring plan to improve the company’s financial position.

It is not necessary for all factors to apply and other matters may be considered. Interestingly, the Explanatory Memorandum to the Bill explains that the phrase “reasonably likely to lead to a better outcome for the company” does not require a better than 50% chance of a better outcome than the immediate appointment of an administrator or liquidator.¹ The Explanatory Memorandum states that “‘reasonably likely’ here requires that there is a chance of achieving a better outcome that is not fanciful or remote, but is ‘fair’, ‘sufficient’ or ‘worth noting’”.²

One would expect that seeking appropriate advice from a restructuring or turnaround adviser will become an important factor in practice. In my view, the proposed safe harbour reforms should provide numerous benefits by:

• encouraging directors to engage early and seek appropriate advice from a restructuring/turnaround expert to form a restructuring plan, rather than placing their company prematurely into administration;
• allowing directors to trade through financial difficulties and take reasonable risk as they embark on a restructure without the fear of personal liability;
• providing the company and its stakeholders (financiers, employees, creditors and shareholders) time to prepare and implement a restructuring plan without the threat of the directors being forced to place the company into administration due to their personal exposure;
• providing a company’s restructuring advisers and key stakeholders time to prepare and implement a restructuring plan; and
• avoiding the value destruction that occurs with the appointment of an administrator or receiver.

The safe harbour reforms will also apply to holding companies. They will protect a holding company from liability for debts incurred by a subsidiary where the directors of the subsidiary qualify for the safe harbour protection, and where the holding company takes reasonable steps to ensure the directors had the benefit of the safe harbour protection.

Reforms relating to ipso facto clauses

In broad terms, an ipso facto clause allows one party to terminate or modify the operation of a contract upon the occurrence of a specific event (eg, the appointment of an administrator).

Ipso facto clauses can lead to the destruction of value in a restructuring and can prevent the successful sale of a business as a going concern. The proposed changes to the enforcement of ipso facto clauses will assist in restructuring businesses in financial trouble. For instance, if the restriction on the enforcement of ipso facto clauses were applicable at the moment, it could assist the administrators of Network Ten in preventing US networks from terminating content agreements which are vital to the ongoing operations of the television network.

The proposed legislation applies to stay on the enforcement of ipso facto clause rights in relation to:

• companies that enter into voluntary administration;
• companies that have a managing controller appointed over all, or substantially all, of their assets (e.g. a receiver and manager); and
• a relevant entity that applies for a scheme of arrangement or compromise.

The stay will apply regardless of whether the right to terminate or amend the contract is self-executing or triggered by one of the parties to an agreement. However, the courts will have the discretion to allow a right to be enforced if doing so would be in the interests of justice. Further, rights can be enforced with the consent of the relevant administrator, managing controller or scheme administrator.

Subject to a court ordering otherwise, the stay on ipso facto clauses will have no impact on a party’s right to terminate a contract for any other reasons. The courts will have the discretion to restrict such enforcement if it appears likely those rights will be exercised merely because of an insolvency event.

Importantly, the federal government has indicated that the changes will not affect some contracts and instruments, including bank loan documents and other financial products (eg, swaps).

The protections against the enforcement of ipso facto clauses will only apply to contracts, agreements or arrangements which are entered into after the commencement of the provisions, which is currently expected to be on 1 July 2018. Therefore, it will take some time before we see the provisions having an impact on any administrations or receiverships.

What should directors do now?

Reform to Australia’s insolvent trading laws and ipso facto provisions are very important in the current climate of business disruption. I call upon Federal Parliament to support these important reforms as I strongly believe they will assist with the successful restructure of businesses and ultimately save jobs.

In the meantime, regardless of whether or not the proposed reforms are passed, it is important for directors to know what to do if they find their company in financial difficulty due to changes in economic conditions, disruption from a new competitor or poor decisions being made.

The message to directors of a company in financial difficulty is simple: “Act early and apply the five golden rules.”

Directors should:

• avoid a “head in the sand” mentality as the problem is unlikely to go away without action. A board should be proactive and act early and quickly;
• increase their monitoring of the financial position of the company if it is facing financial difficulty. In particular, directors should adopt more vigorous safeguards including increased monitoring of the company’s bank facilities, its cash flow, current assets and current liabilities;
• seek legal and financial advice and develop a “plan B”. Directors of companies often rely upon the injection of fresh funds from an asset sale or a capital raising to emerge from financial difficulty. But what if that transaction was to fail or bedelayed? Is there a plan B? Can debts be paid in the meantime? Boards should seek legal advice on their duties and restructuring advice from a restructuring and turnaround professional;
• engage with banks and other financiers sooner rather than later, whether the organisation is a
• giant or small in size. Banks are more likely to support a borrower that is proactive and engages with them. If the banks have confidence in directors and their advisers, they can be expected to constructively engage; and
• understand the time that may be required. Restructures and turnarounds can take time to prepare and implement. They can be very complex and require the input of many stakeholders, especially for large companies. Some may require a formal scheme of arrangement that will take several months to implement.

The precise steps that directors will need to take in any particular case will depend on the circumstances, but what is crystal clear is the importance of acting early. Doing so can dramatically increase the chances of a company trading out of financial difficulty, and also reduce the risk that a director may be held liable for insolvent trading.