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History of Insolvent Trading Provisions
The Harmer Report, where it all began…
On 20 November 1983, the federal Attorney-General called for an inquiry “…into the law and practice relating to the insolvency of both individuals and bodies corporate, in particular – (b) Parts VIII, X, XII of the Companies Act 1981 so far as they are related to or are concerned with the insolvency of companies; (c) any related matter.”1
The result was the Law Reform Commission Report No. 45 General Insolvency Inquiry; referred to as ‘The Harmer Report2 , (so named after the Commissioner in charge, Mr Ron W Harmer). Little did we know in 1988, that this report would be responsible for the introduction of two new legislative schemes. These were (through Corporate Law Reform Act 19923):
- The Voluntary Administration regime4; and
- Director liability and disqualification5 in so far as dealing with a director’s responsibility to avoid incurring debts (and continuing to trade) whilst a company is insolvent.
These changes reflected Australia’s first step towards corporate rescue and aimed to shift some of the cost of corporate failures to the director personally. This was primarily achieved by codifying director (fiduciary) duties around insolvent trading, converting the breach of duty from a criminal offence6 to a civil one (in the absence of dishonesty)7 and allowing a Liquidator to pursue a director, on behalf of the company’s creditors.
How effective has the insolvent trading regime been?
There are many obligations and duties of a director in operating a company responsibility, one of which is the requirement to ensure the company does not continue to trade whilst it is insolvent (unable to meet its debts as and when they fall due8). These provisions are designed to penalise a director that has taken unreasonable trading risks. However, it is argued they have the undesired effect of restricting responsible risk-taking activity9.
The insolvent trading provisions are currently embedded into section 588G of the Corporations Act 2001 (Cth) and provide directors that have acted responsibility with reasonable defences to any such claims brought by a liquidator.
Since its introduction, there has been debate over the stringency of Australia’s insolvent trading laws, especially compared with other developed countries. However, using law to balance punishment for irresponsible corporate decisions and allowing entrepreneurial activity is problematic.
The debate generally turns on:
The Global Financial Crisis (GFC) ignited the debate again, with industry stakeholders drawing the focus to the punishment being too severe. An article called ‘Director liability for Insolvent Trading: Is the cure worse than the disease?; the author10 calls for flexibility in Australian insolvent trading laws so that directors can effectively navigate their corporations through the storm of the changing market conditions faced post GFC.
“ I am certainly aware of the debate and of the claims, for example, that directors are reluctant to take on that role for fear of personal liability. That said I would stand by the present insolvent trading regime which seeks to avoid a circumstance where unsecured creditors are called upon, to assume the ‘equity capital’ risk of the company’s ongoing trading. The duty to prevent insolvent trading already imposes on a director some expectation of foresight and planning, to anticipate when things are going wrong and to seek advice accordingly. I appreciate, though, that some in the insolvency profession quite properly raise the need for flexibility in the process, short of Part 5.3A being invoked. It may well be that some ‘fine tuning’ of this aspect of our insolvency law is appropriate. Once such proposal has been to extend the defence provided by the ‘business judgement rule’ to an insolvent trading claim on which I am aware the IPA has made submissions.”
Formal consultation through Treasury’s corporations and financial services division occurred in January 201013, submitted the following three solutions to address this issue that:
- no change to the Corporations Act 2001 (Cth) (the CA) insolvent trading provisions;
- additional defence available to directors based on the ‘business judgement rule’ in section 180 of the CA; or
- ability of the director, in agreement with creditors, to invoke a moratorium for the purpose of reorganising the company outside of external administration.
The first recommendation was adopted and no change to the provisions were made.
In response to several related Government inquires, the Australian Restructuring Insolvency and Turnaround Association (ARITA) released a discussion paper titled A Platform for Recovery: Dealing with Corporate Financial Distress in Australia in October 2014, which provided further discussion on the benefits of safe harbour provisions.
In essence, when directors seeks genuine restructuring, it is argued they should have a defence based on the business judgement rule14. This, coupled with the guidance of an adequately experienced professional, termed a Chief Restructuring Officer, would allow directors to access adequate informal restructuring services when a company is in a financial distress situation.
The Productivity Commissions report No.75 also addressed the issue in December 201515 and provided detailed recommendations on the creation of a safe harbour for directors to allow for informal restructuring through the use of an appropriately qualified advisor.
Bringing us to today… the proposed safe harbour laws
Through the Turnbull Governments National Innovation and Science Agenda and based on the Productivity Commission’s recommendations, this issue was addressed through:
- On 29 April 2016 Treasury released a consultation paper16 was released for public comment on improving bankruptcy and insolvency laws, which introduced two potential models to provide a safe harbour from insolvent trading. Model A provided for an additional defence in the circumstances where genuine informal restructuring was pursued and Model B provided a carve out of the insolvent trading provisions which allowed directors to retain control without the requirement to seek assistance from a restructuring advisor;
- Following this, on 28 March 2017 an exposure draft of legislation was released for consultation which was predominately based on Model B and provided more flexibility through:
- the protection being available from the time the director starts taking a course of action (after the Director suspects the company may become insolvent) and will apply until either the course of action ends or it stops being ‘reasonably likely’ to produce an outcome better than voluntary administration or liquidation; and
- in determining what is ‘reasonably likely’ to produce a better commercial outcome than formal insolvency is an objective one and the onus to prove this objective standard was not met would be borne by a liquidator;
- On 1 June 2017 the draft bill Treasury Laws Amendment (2017 Enterprise Incentives No.2) Bill 201717 was introduced in the lower house and at the second reading there were several concerns raised, the key comments being
“….While the industry as a whole believes that the intent of this bill is very good, not everybody believes that it is in its best form at the moment. The Shareholders’ Association, for example, has concerns for its members, who are shareholders in some of the companies that will be affected by this bill. The Productivity Commission has made a number of recommendations, none of which are in this bill. So there is another course of action recommended by the Productivity Commission, and we need to consider whether we are looking at an exemption or a defence model. So there are things for us to work through, and it will be great to watch the Senate inquiry take place. It will be good to see the submissions so that we can fully understand exactly how this works……”18
“….When we are dealing with this specific bill, this proposal for a safe harbour, we are really talking about creating a safe harbour in respect of a provision that prohibits insolvent trading by corporations. It is worth noting that the proceedings concerned are very rarely actually brought. The Productivity Commission dealt with this point before recommending a safe harbour defence when they said:
… the spectre of action looms larger than the actual (likely) consequence. The rate of successful enforcement of insolvent trading actions is low. There were only 103 insolvent trading cases between the law’s introduction in 1961 and 2004.
The commission went on to say: While the court ordered that compensation be paid in three quarters of those cases, more serious sanctions were extremely rare. Only 15 per cent of cases involved criminal proceedings, and only two cases involved an order banning directors from managing companies.
The commission went on to say: Since 2004, ASIC reports that they have commenced action for insolvent trading for circumstances involving five companies only between 2005 and 2011.
…..Of course, this bill is concerned with the civil proceedings under the insolvent trading provisions of the Corporations Legislation, and it follows on from the Productivity Commission recommendation for the creation of a safe harbour defence. The Productivity Commission recommended that the Corporations Act should be amended to allow for a safe harbour defence to insolvent trading. It went on to suggest some conditions for the availability of the defence, saying that defence would only be available when directors of a company have made and documented a conscious decision to appoint a safe harbour advisor with a view to constructing a plan to turn around the company; the advisor was presented with proper books and records; the adviser had at least five years’ experience; the directors were able to demonstrate they had taken all reasonable steps to pursue restructuring; and the advice had to be proximate to the specific circumstance of financial difficulty, not a set of advice much earlier in relation to something else. There are some other components of the recommendation that are relevant, but readers can have a look at the report themselves.”19
- Following the readings in the lower house, on 15 June 2017 the bill was referred to the Senate Economics Committee for inquiry, with the committee report due by 8 August 201720.
So the debate remains open. We are sure that Australian insolvent trading provisions as they currently stand will be reformed through the proposed safe harbour laws, however, the final application of them remains unresolved.
For further Safe Harbour advice or if you require one of our expert management consultants visit our Contact Us page
Article written by Nicky Lonergan
Chief Operations Officer, SV Partners.
- Law Reform Commission Report No. 45 General Insolvency Inquiry (The Harmer Report); terms of reference.
- Australian Law Reform Commission General Insolvency Inquiry, Report No.45 (1988) chapter 7
- which commenced on 23 June 1993
- Part 5.3A of the Corporations Act 2001 (Cth) (the Act)
- Repositioned the law from s592 and 593 of the Corporations Law (derived from ss.556 & 557 of the Companies Code)
- s.592 created a criminal offence which carried maximum penalty of $5,000 or one year imprisonment, or both. If convicted, ASIC or a creditor could then, pursuant to s593, apply to Court for a declaration that the convicted person pay whole or part of the debt. The liquidator had not means to pursue a civil remedy on behalf of the company for the benefit of creditors as a whole (http://www.austlii.edu.au/au/journals/BondLawRw/1993/11.pdf)
- Harris, J. Article: Director Liability for Insolvent Trading: Is the Cure Worse than the Disease? Reference 22 page 4
- Section 95A of the CA
- Insolvent Trading: A safe harbour for reorganising attempts outside of external administration
- Harris, J. Article: Director Liability for Insolvent Trading: Is the Cure Worse than the Disease?
- Murray, M. Australian Insolvency Journal October – December 2007, Vol 19, No.4 4-6, 8-9: An interview with Richard Fisher
- A commissioner on the then Law Reform Commission’s General Insolvency Inquiry (which produced the Harmer report)
- Insolvent Trading: A safe harbour for reorganising attempts outside of external administration
- ARITA discussion paper: A Platform for Recovery Dealing with Corporate Financial Distress in Australia: October 2014
- Productivity Commission Inquiry Report No. 75: Business Set Ups, transfers and Closures, 30 September 2015 (the PC report)
- On 1 June 2017