Economists cannot agree if Australia will enter a recession in 2023 but it is clear that businesses will face an economic downturn at a time when they are also battling: global uncertainty, rising inflation, supply chain issues, falling consumer demand, higher interest rates, rising labour costs, rising energy costs and delays in collections from their debtors. These factors are placing liquidity pressures on businesses.

Several sectors such as the construction industry are already suffering the impact of rising building costs, labour shortages and fixed price contracts, particularly in the residential market. This has resulted in the collapse of many building companies throughout Australia.

Directors are always striving to improve the financial performance of their businesses. But when facing an economic downturn in such a challenging environment, the usual measures to improve performance may not be sufficient and directors may face short term cash flow shortages or worse.

Directors need to act early and take proactive steps which may include taking steps to improve operational and financial performance, putting in place a formal turnaround plan and seeking to rely upon the safe harbour regime or if necessary, entering voluntary administration. Acting early dramatically increases the chances of a company trading out of financial difficulty and reduces the risk that a director may be held personally liable for insolvent trading debts or for breaching their directors’ duties.

Insolvent trading

Directors in Australia face some of the harshest insolvent trading laws in the world. Australia’s insolvent trading laws mean directors (including non-executive directors) may face personal liability when their company is in severe financial difficulties.

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 (on an objective basis) 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. Generally, a company is insolvent if it is unable to pay its debts when they fall due. Often these circumstances are considered by liquidators with the benefit of hindsight who usually conclude that the company may have been trading insolvent for a prolonged period pre-liquidation.

But directors may be able to find some protection in the safe harbour regime when they are facing financial difficulties such as cash flow shortages.

Can the safe harbour regime help directors?

The safe harbour regime is designed to give company directors breathing space (and protection from insolvent trading personal liability) in circumstances where a turnaround plan is being pursued. It is designed to support a culture of entrepreneurship and provide breathing space for a business facing short term financial difficulties.

The safe harbour protections are intended to encourage and support directors who make early, genuine and potentially ongoing attempts to restructure their companies in an effort to avoid formal insolvencies and the associated detrimental impacts on all stakeholders including employees, creditors and shareholders.

In short, if directors take appropriate steps such as obtaining expert advice and preparing a turnaround plan that is reasonably likely to lead to a better outcome for the company (and its creditors), than an insolvency appointment, they can protect themselves from liability for insolvent trading. During such a period, in order to meet their duties to the company, the directors must also have regard to the interests of the company’s creditors.

The safe harbour protection provisions provide directors with a “defence” (carve-out) from personal liability for insolvent trading where:

• The director, or board of directors, suspects the company may become or is insolvent.
• The board of directors start developing a turnaround plan that is reasonably likely to lead to a better outcome than the immediate appointment of an administrator or liquidator to the company.
• The company incurs a debt (which might otherwise lead to insolvent trading liability for a director) directly or indirectly in connection with the turnaround plan that the board of directors is developing.
• The relevant debt is incurred within the period beginning when the directors start to develop the turnaround plan, and ending when the turnaround is discontinued, or not pursued within a reasonable time, or ceases to be likely to produce a better outcome for the company, or an external administrator is appointed.

Importantly, in order for the safe harbour regime to apply, the company’s directors must ensure that:

• All employee entitlements are paid by the time they fall due; and
• All tax reporting obligations such as the giving of notices, statements, applications and other documents are completed and submitted per the Income Tax Assessment Act 1997 (Cth).

There are also additional conditions which need to be met in order for directors to qualify for safe harbour protection.

In determining whether a turnaround plan was reasonably likely to lead to a better outcome for the company (and its creditors), the Court will look at factors such as whether a director:

• Informed themselves about the company’s financial position;
• Took steps to prevent misconduct by officers and employees;
• Took appropriate steps to ensure the company maintained accurate financial records;
• Obtained advice from appropriately qualified advisers, and
• Took appropriate steps to develop and implement a plan to restructure the company to improve its financial position.

Directors should try and meet all of these factors (or as many as possible) to maximise the prospect of safe harbour being available to them.

Seeking appropriate advice from a qualified restructuring or turnaround adviser is a critical factor. Apart from obtaining appropriate advice on a restructure plan, the adviser also needs to continually monitor the turnaround plan to ensure the plan is reasonably likely to lead to a better outcome than the company’s immediate administration or liquidation.

What should directors do?

Our message to directors is simple: Act early and apply five golden rules.

Directors should:

1. Avoid a “head in the sand” mentality as the problem is unlikely to go away without action, particularly in the current economic climate. A board should be proactive and act early.
2. Increase their monitoring of the financial position of the company if it is facing financial difficulty. Directors should adopt more rigorous safeguards including increased monitoring of the company’s bank facilities, its cash flow, current assets and current liabilities.
3. Seek legal advice and financial advice from an experienced restructuring and turnaround adviser (such as a member of ARITA or TMA Australia) and develop a “turnaround plan”. Turnaround plans will depend on the particular circumstances and may include:
• Measures to improve operational performance
• Restructuring existing debt facilities, entering standstill arrangements with major financiers and key creditors
• Exploring alternate avenues of credit
• Capital raisings
• Improving account receivable measures
• Reviewing supplier terms and key contracts in an attempt to reduce costs
• Reducing labour costs and undertaking redundancies
• Selling assets; and
• Converting debt to equity.
4. Engage with banks, other financiers and other key stakeholders sooner rather than later. 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.
5. 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 and co-operation of many stakeholders, especially for large companies. Some may require a formal scheme of arrangement that requires the approval of the Court and will take several months to implement.

Directors of publicly listed companies need to take extra care as the Australian Stock Exchange does not generally provide relief from a listed entity’s disclosure obligations in times of financial difficulty.

Using Voluntary Administration

Of course, a company may not have the option or luxury of time to enter negotiations with creditors and other stakeholders to implement a consensual turnaround plan. And in the current and fast changing financial environment the need to restructure through voluntary administration may be the most appropriate option.

The Voluntary Administration (or Administration) insolvency process is the closest Australia has to the USA’s Chapter 11 and it can be effectively used to restructure and save the underlying business of a company.

Administration is the process under which an independent Administrator (an expert insolvency accountant) takes control over the affairs of a company which is, or likely to become insolvent. An Administrator is normally appointed by the company’s board of directors.

Importantly, administration does not mean the death knell of a company or its underlying business. Administration provides companies that are in severe financial difficulties or insolvent with a chance to restructure their financial affairs or to sell their business as a going concern.

A key benefit of administration is that when a company enters administration, it immediately gains the benefit of a statutory moratorium which can protect it from action by lessors and other creditors providing it, and the Administrator, with valuable breathing space. Administration may also prevent third parties (such as key suppliers or customers) from terminating certain contracts as a result of statutory "ipso facto" protections.

Administration can be a very flexible process. A restructure through an administration may result in the implementation of a proposal where creditors agree to accept a certain percentage of their debts and the business continues, or the sale of the underlying business or a complex restructure involving a debt for equity swap.

In recent years, Virgin Australia Airlines and Probuild Constructions entered administration and were successfully restructured.

Act early and be proactive

The actions 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 and taking proactive steps whether or not you are seeking to implement a turnaround plan and rely upon safe harbour provisions or enter administration. 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 personally liable for insolvent trading or for breaching their duties. And importantly, acting early and seeking advice from a restructuring and turnaround adviser can help lift the anxiety and stress felt by directors when their businesses face financial difficulties.

The Dentons Restructuring, Insolvency and Bankruptcy team is here to help you and your clients navigate any challenges ahead. 

Thanks to Annabelle West for her assistance with this article.