COVID-19, business insolvency issues and safe harbour protections

During the second half of 2019, it was generally accepted that the US/China trade war was the most likely macroeconomic event that would precipitate a global slowdown. Even then, given the enormous amount of ‘dry powder’ capital that was available in the market, the downturn, if any, was expected to be mild. 

As it turned out, GDP in Australia grew by 0.5 percent for the December quarter, slightly more than forecast by most leading economists, and largely immune from the global trade war fallout. However, along came the devastating bushfire season and now we have the coronavirus (COVID-19). 

Even at this relatively early stage, much is being written about the supply and demand side shocks that COVID-19 will cause and businesses with unfulfilled contracts are closely scrutinising force majeure provisions.

The anticipated disruption to business has the potential to cause solvency, not just liquidity, issues for global enterprises. The test for insolvency in Australia is whether a business can pay its debts as and when they fall due, i.e. it is a cash flow, not balance sheet test.

Directors of Australian companies have a clear obligation to ensure a company does not incur debts while insolvent. If they breach this duty, the director can be personally liable to pay the debts the company incurs under section 588G Corporations Act 2001 (Cth) (Act). Insolvent trading liability will arise where:

1. A company incurs a debt while insolvent (or becomes insolvent by incurring that debt);
   
   
2. There are reasonable grounds for suspecting company was insolvent (or would become insolvent) when that debt was incurred; and
   
   
3. The director is aware of such grounds or a reasonable person would be. 

However, directors can seek sanctuary from personal liability under the Safe Harbour regime, which is a relatively recent addition to the Act.  The safe harbour defence is aimed at encouraging directors to keep control of their company during times of financial distress and allow them to focus on the needs of the company rather than their potential personal liability. 

For the defence to apply, the following elements must be satisfied:

• The director must suspect the company is or may become insolvent.
  
  
• The director (ideally the board) must “start developing one or more courses of action” reasonably likely to lead to a “better outcome” for “the company” in comparison to an immediate liquidation or administration (section 588GA(1)(a)) Corporations Act.
  
  
• Because the safe harbour is relatively new, there is no judicial guidance as to the meaning of “the company” or how a “better outcome” is to be assessed. It is broadly accepted in the insolvency community that the interests of creditors should be given a high priority and a better outcome is best assessed by obtaining a liquidation valuation of the assets and undertaking of the company.
  
  
• Section 588GA(2)) provides a non-exhaustive list of examples of the courses of action that could lead to a better outcome including:
  
  
  • Directors properly informing themselves about the company’s financial position.
    
    
  • Taking steps to prevent misconduct by the company’s officers that could adversely affect the company’s ability to pay debts.
    
    
  • Taking steps to ensure company is keeping appropriate financial records.
    
    
  • Developing or implementing a plan for restructuring the company to improve its financial position.
    
    
  • Obtaining advice from an appropriately qualified entity, who has been given sufficient information to give appropriate advice. It is generally accepted that this will usually mean engaging an insolvency practitioner to advise on the counterfactual liquidation/administration scenario and financial viability of the plan for restructuring. 

The defence applies to debts incurred in connection with the ’courses of action’ but not all debts. However, if a course of action includes the business continuing to trade, one could expect the vast majority of debts incurred in the ordinary course of business would fall within the safe harbour.

The safe harbour does not affect any other duties of a director which must continue to be complied with.

Directors may lose the protection of safe harbour if at the time the debt is incurred the company is failing to substantially comply with its obligations to pay employee entitlements, including superannuation contributions when they fall due, or the company is failing to substantially comply with its notice and reporting obligations under the relevant income tax laws.

Whether the safe harbour will be available will be retrospectively assessed. It is therefore critical that directors keep appropriate records of their decisions. The defence will not be available if directors who do not turn their minds to the issue.