25 March 2020
The recent decision to suspend insolvent trading laws in the face of the COVID-19 crisis leaves open the possibility that, absent meeting the criteria for the statutory safe harbour defence, insolvent companies may temporarily continue to trade without exposing directors to insolvent trading liability. However, directors will need to take particular care to consider the interests of creditors in their decision-making if they are to avoid alternative claims for breaches of directors duties in the event of a subsequent corporate insolvency.
Directors owe duties to consider the interest of creditors in the zone of insolvency, independent of the duty to avoid insolvent trading.
A failure to act with due diligence and care in relation to the management of company that prejudices creditors may leave directors personally exposed to claims by the company (either directly, on a derivative basis or by external administrators).
In a meaningful sense, directors are still caught between a rock and a hard place in attempting to chart a course through the current COVID-19 crisis.
The content of the duty to creditors is inexact and somewhat disputed.
The duty is said to arise when the company is insolvent, near insolvent or of doubtful solvency, which means that it arises when, as a matter of commercial reality, the company is unable or appears unable to meet its obligations as and when they fall due (including, where with a high degree of certainty it will find itself unable to meet its obligations in the future).
The obligation to consider the interests of creditors probably extends to future creditors, or likely creditors but certainly captures existing creditors but is definitely not independently actionable by creditors. Despite occasional suggestions to the contrary, creditors cannot enforce the duty directly and any loss must be the company’s loss.
In Kinsela v Russell Kinsela Pty Ltd (in liq), Chief Justice Street explained the basis of the duty in terms that:
“…where a company is insolvent the interests of the creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company's assets. It is in a practical sense their assets and not the shareholders' assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration.”
What does a duty to consider the interests of creditors practically resemble? A duty to consider a matter is not a duty to give overriding emphasis to the position of creditors as compared to shareholders. As expressed in The Bell Group Ltd v Westpac Banking Corporation Ltd:
…[I]t would be going too far to state, as a general and all-embracing principle, that when a company is in straitened financial circumstances, the directors must act in the interests of creditors, or they must treat the creditors' interests as paramount, to the exclusion of other interests. To do so would come perilously close to substituting for the duty to act in the interests of the company, a duty to act in the interests of creditors
One way to frame the duty to consider the interests is in the context of discharging the duties owed by directors and officers under sections 180-181 of the Corporations Act 2001 (Cth) to act with care and diligence and for a proper purpose.
Section 180 imposes a requirement of skill and care on directors and officers in discharging their duty. A director will be liable for making negligent or reckless decisions under this section, but may fulfil their duties by bringing their decisions inside the business judgment rule (which involves basic duties of having adequate information, a proper purpose, making enquiries and a rational belief that the decision is in the best interests of the corporation. Section 181 imposes a duty to act in the best interests of the corporation.
Where the interest of the corporation include at least notionally a duty to consider the impact of certain decisions on the position of creditors, the content of the duty becomes more understandable.
Like most other aspects of directors’ duties in Australia, the discharge of the duty is in some respects procedural. Subject to arriving at a decision which falls within the range which might reasonably be arrived at by a proper consideration of the relevant facts and circumstances (including prejudice to creditors), a director will have discharged their duty.
Ordinarily, the content of this duty is un-extraordinary. A decision which is obviously disastrous for the creditors of a company nearing insolvency will be, irrespective of insolvent trading laws, potentially a breach of a directors duties actionable by the company. The loss arising by that decision will be the loss occasioned to the company by the breach. While there is some doubt that all further trading losses will be recoverable from a misfeasant director who decides to press on- losses directly flowing from the breach will be recoverable.
With a range of extraordinary measures being instituted in response to the COVID-19 emergency and the suspension of insolvent trading laws, directors are now being asked to make extraordinary decisions about weathering the economic storm.
Some corporations face a complete shutdown and loss of revenue. Others have their plans in ruins and face a period of improvisation, making do and hoping for the best. Realistically, no one is in a position to say when the crisis will end (beyond 12 months perhaps) or what the economic landscape might look like at the conclusion of the crisis. It may be in the circumstances impossible to form a rational view as to what happens. It may be that in various parts of the world the crisis plays out more quickly than 12 months bringing with it substantial human consequences which may be equally or more economically disastrous than a prolonged period of social distancing.
In these circumstances, a marginally solvent corporation with falling revenue risks completely dissipating its assets for no return and having insufficient working capital to trade out the other side. Even if a company can trade out, it may have an unsustainable debt burden that will eventually and almost inevitably force it into insolvency.
If a company is presently able to marginally meet its obligations as and when they fall due, then the question is, can a director acting with care necessarily take the decision to press on?
If a board decides to incur the risk of pressing on and the company trades out of difficulties, then practically any question of a breach of directors duties is unlikely to emerge.
If a board decides not to press on, it will potentially face allegations from shareholders of failing in their duties. In this respect, one unsatisfactory aspect of the duty to consider the interests of creditors emerges in so far as the interests of shareholder may well be, in circumstances where there capital is worthless, or near worthless to take risks in order to potentially recover value, even if this means sacrificing the interests of creditors. Putting directors in a position where they will face litigation over whether a balancing act was struck with care and diligence is potentially unsatisfactory.
However, if a board does decide that a company should press on and its fail, it is almost certain that in the context of a large corporate insolvency, a liquidator or receiver and manager will give consideration to whether the directors acted with due care and skill in making that decision. This consideration is in some cases likely to be driven by the potential to recover any loss flowing from a breach of duty from insurers or high net worth directors.
Years from now, a director may well be asked to explain on what basis they believed that the corporation, nearing or past the point of insolvency, could trade out of difficulty against the uncertainties of the current crisis. Absent a well articled, written restructuring plan supported by robust financial analysis these questions will be difficult to answer. It may be that putting in place a safe harbour style plan is the best way to have in place a robust answer to the questions that may be asked.
One point of particular consideration is that decisions to obtain further credit, dispose or restructure certain subsidiaries are highly likely to be the subject of investigation and scrutiny. These decisions will stand out as having particular loss attached to them and avoiding some of the issues that exist in relation to more nebulous claims.
Unlike insolvent trading laws, liability for a breach of directors’ duties can be avoided by taking proper care and acting in the interests of the company – it is not a strict liability position. Whether taking proper care practically looks any different from the steps required to obtain a safe harbour defence remains open to question.
However, where a decision does fall short of standard, in circumstances of a (hopefully) once in a generation event, the Court has a power to excuse directors who have acted honestly and in good faith from any failing in their duties. While this power is seldom used, these circumstances may be ones in which the Court would consider granting such relief.
While insolvent trading laws are suspended, directors and officers will continue to face thorny issues in dealing with corporations which are insolvent or approaching insolvency.
This article is part of our insight series COVID-19: Navigating the implications for business in Australia and beyond. To get notified by email when new COVID-19 insights are released, please subscribe for updates here.
This publication is introductory in nature. Its content is current at the date of publication. It does not constitute legal advice and should not be relied upon as such. You should always obtain legal advice based on your specific circumstances before taking any action relating to matters covered by this publication. Some information may have been obtained from external sources, and we cannot guarantee the accuracy or currency of any such information.