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Safe Harbour and Ipso Facto insolvency law reforms - What you need to know
On 28 March 2017 the Federal Government released for public consultation draft legislation (Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 – Exposure Draft) that seeks to amend the Corporations Act 2001 (Cth) (Corporations Act) by introducing:
- a ‘safe harbour’ carve out to a director’s personal liability for insolvent trading; and
- stay provisions affecting the enforceability of certain ‘ipso facto’ and other clauses during an administration or a scheme of arrangement.
The draft legislation is long awaited. Following recommendations by the Productivity Commission in its Inquiry Report: Business Set-Up, Transfer and Closure (30 September 2015), the Federal Government included in its National Innovation and Science Agenda (7 December 2015) a commitment to introduce safe harbour and ipso facto reforms (inter alia) with the aim of promoting a culture of entrepreneurship and innovation in Australia. The precise form of the changes was refined through a Proposals Paper released in April 2016 and public consultation on the various models outlined in the Proposals Paper, which concluded in May 2016.
Currently, a company director may be liable under Australia’s insolvent trading provision (i.e. section 588G(2) Corporations Act) if:
- they are a director at the time when the company incurs a debt;
- the company is insolvent at that time, or becomes insolvent by incurring that debt; and
- at that time, there are reasonable grounds for suspecting that the company is insolvent or would become insolvent.
The proposed new section 588GA introduces a carve out to section 588G(2) Corporations Act, such that directors will not be liable for certain debts incurred whilst insolvent if after suspecting insolvency, the director starts taking a course of action reasonably likely to lead to a better outcome for both the company and its creditors as a whole, than becoming a Chapter 5 body corporate (i.e. a company that is being wound up, that has a receiver appointed to it, that is under administration, that has executed a deed of company arrangement that has not been terminated or entered into a compromise or arrangement the administration of which has not been concluded).
In determining whether a director’s course of action is “reasonably likely to lead to a better outcome”, the draft legislation provides that regard is to be had to the following non-exhaustive list of factors, that is, whether the director has:
- taken steps to prevent misconduct within the company that could adversely affect the company’s ability to pay all its debts;
- taken steps to keep appropriate financial records;
- obtained appropriate advice;
- informed himself or herself of the company’s financial position; and
- been developing or implementing a plan for restructuring the company to improve its financial position.
According to the Explanatory Memorandum, this list of factors is intended to act as a guide only to the additional steps a director may consider taking and it is not necessary for any or all of these factors to be present in order for safe harbour to apply. What is critical is that once it becomes reasonably apparent that the company is not viable, the director either makes adjustments to the course of action to ensure it is still reasonably likely to lead to a better outcome or, if that is not possible, places the company into voluntary administration or takes steps to have the company wound up.
Although section 588GA has been framed as a carve-out to Australia’s insolvent trading provision (i.e. section 588G(2) Corporations Act), a director who wishes to rely on safe harbour in section 588G(2) proceedings will need to point to evidence that suggests there was a reasonable possibility that a course of action reasonably likely to lead to a better outcome for the company and its creditors, was taken. The Explanatory Memorandum indicates that once this low evidential burden is met, the onus of proof then shifts to the liquidator alleging a contravention of section 588G(2) to prove that safe harbour does not apply.
Safe Harbour - what should directors be aware of?
It is important for directors to appreciate that:
- the safe harbour rule does not cover all debts. It only covers debts that are incurred:
- in connection with the course of action; and
- during the period commencing when the course of action is first taken and ending the earliest of (a) when the director ceases the course of action, (b) when the course of action is no longer reasonably likely to lead to a better outcome and (c) when the company is placed into external administration.
In terms of new money, the Explanatory Memorandum notes that directors will not be protected in relation to incurring new debt from creditors where the directors do not believe the company can repay the debt in accordance with its terms. Directors will need to be mindful of this when negotiating the terms of any new financing.
- Directors cannot rely upon safe harbour in circumstances where the company is not meeting its obligations in relation to employee entitlements (including superannuation contributions) and its taxation reporting obligations, in a manner consistent with a company that is solvent. It is not entirely clear what this will require in the case of employee entitlements. For example, does it require a company to put money aside to cover entitlements in a formal insolvency or, to assess that there will be sufficient realisations in a formal insolvency to cover entitlements.
- Directors will be prevented from using books and information about a company as evidence that they took a reasonable course of action if they have previously failed to provide these materials to a liquidator or administrator following an appropriate request for such materials. This requirement is designed to ensure that where a company eventually enters administration or is wound up, the directors do not try to prevent the liquidator or administrator from investigating the company’s activities, by withholding books or information about the company. This rule will not apply if:
- the director did not possess the books or information at the relevant time and there were no reasonable steps the director could have taken to obtain the books or information; and/or
- the liquidator or administrator failed to inform the director of the effect of failing to comply with the request for materials.
If enacted, the safe harbour provisions will commence the day after the bill receives Royal Assent and will apply to actions taken before, at or after commencement, but only in respect debts incurred at or after commencement.
Additional comments on safe harbour
In our view, the safe harbour reforms do not go far enough. Company directors are unlikely to be reassured by being able to avail themselves of another defence to an insolvent trading claim. The threshold for bringing a claim needs to be changed. In our view, legislation similar to that in the United Kingdom should be introduced. We would suggest that a liquidator only be able to bring an insolvent trading claim if the liquidator was able to demonstrate that there had existed a less than reasonable prospect of a company surviving.
Stay on the enforcement of ‘Ipso Facto’ clauses
An ‘ipso facto’ clause is a contractual clause that allows a party to terminate or modify a contract upon the occurrence of certain events. Where such clauses can be triggered solely by virtue of the occurrence of an insolvency event - which term is often defined to include the appointment of voluntary administrators or the entry into a scheme of arrangement, and often without regard to the relevant company’s ability to continue to perform its contracts - such clauses are generally regarded as a significant impediment to a successful restructure as they can:
- reduce the range of restructuring options available to the company; and
- be highly destructive to both the value of the company’s business and the potential return to creditors (due to such clauses’ ability to disturb the business’s contractual arrangements and destroy goodwill).
The proposed new sections 415D-F and 451E-G will introduce two kinds of stay provisions:
- an automatic stay on ipso facto rights triggered by administration and schemes; and
- stay orders in respect of a potentially broader range of rights (e.g. termination for convenience rights), where a court is convinced such rights are or might be exercised or there is a threat that they might be exercised solely because the company has entered administration or a scheme of arrangement.
Automatic Stay for Ipso Facto rights triggered by administration and schemes
The proposed new sections 415D and 451E will introduce an automatic stay on the enforceability of certain ‘ipso facto’ clauses that allow a contract to be terminated or varied, merely because a company has entered into a scheme of arrangement or administration (Automatic Stay). The Automatic Stay will operate:
- in the case of a scheme, from the time the company makes an application under section 411 to hold a scheme meeting (which application must state it is being made so that the party can avoid being wound up in insolvency), until the application is withdrawn or dismissed by the Court or the scheme of arrangement comes to an end; and
- in the case of voluntary administration, from the time an administrator is appointed until the time the administration ends, unless:
- the administration ends because a resolution or order is passed that the company be wound up, in which case, the stay ends when the company is wound up; or
- the company’s creditors vote in favour of a deed of company arrangement (DOCA) proposal at the second creditors’ meeting under s439A and within 7 days after the DOCA is executed, the deed administrator applies for orders extending the Automatic Stay (Extension Order), in which case the Automatic Stay ends when the application is withdrawn or dismissed or (if the application is granted) when the Extension Order ceases to be in force.
Conversely, any right under the subject contract that the company undergoing the restructure has for the provision of additional credit will also be unenforceable during the period where the stay on enforcement of the ‘ipso facto’ clause applies.
Directors should be aware that:
- the Automatic Stay will not apply to all contracts. The stay will not apply to:
- ipso facto rights that manage financial risk associated with financial products regulated by Chapter 7 of the Corporations Act and are necessary for the provision of financial products of that kind; or
- other types of contracts or contractual rights prescribed in the regulations or by ministerial declaration.
In an Explanatory Note on the Treasury’s website, the Federal Government has set out a list of 16 types of contracts that it proposes to exclude by regulation and is seeking feedback on the appropriateness of the contracts in that list.
- Under the proposed new sections 415E and 451F, courts will have the power to lift the Automatic Stay in respect of certain ipso facto rights if satisfied that doing so is in the interests of justice or (in the case of a scheme only) the relevant scheme is not for the purpose of the company avoiding being wound up.
Stay Orders in respect of potentially broader range of contractual rights
Under the proposed new sections 415F and 451G, courts will also be able to make orders that for a period of time specified in the order (which period must not exceed the duration of the Automatic Stay), one or more rights under a contract may only be enforced with the leave of the Court or on terms imposed by the court (Stay Orders), if the court is satisfied that the relevant right:
- is being exercised;
- might be exercised; or
- there is a threat that it might be exercised,
merely because the company is under administration or subject to a s411 application or scheme of arrangement (as relevant). Courts will only be able to make Stay Orders on an application by the administrator or in the case of a scheme, if the application for the Stay Order is included in the section 411 application or (once the scheme is approved) made by the scheme administrator. We note that it is also possible for a court to make interim orders before deciding an application for a Stay Order.
While it is clear that Stay Orders may not be granted in respect of rights specifically carved out from the operation of the Automatic Stay (see discussion above), as there are no other limitations on the types of contractual rights which may be the subject of Stay Orders, it appears to be the drafters’ intention that Stay Orders will be able to be made in respect of a potentially broader range of contractual rights than the Automatic Stay. In this regard, we note the drafting note within the draft legislation which states that a Stay Order could be sought for example, in respect of a right to terminate for convenience.
If enacted, the stay provisions will commence the later of 1 January 2018 and the day after the bill receives Royal Assent and importantly, only apply to rights arising under contracts entered into after commencement.
Additional comments on the stay provisions
It is disappointing to see that as presently drafted, the Automatic Stay (and thus the potential operation of Stay Orders) will not be permanent, unlike in the United States where under section 365(e)(1) of the Bankruptcy Code, ipso facto clauses are generally unenforceable at any time after bankruptcy proceedings have commenced. Once the Automatic Stay lapses, there is nothing to stop contractors exercising their ipso facto rights against a successfully restructured company (unless of course, their ipso facto rights can only be exercised whilst the relevant administration or scheme event is continuing or subsisting). In our view, the current drafting imposes a heavy burden on companies to ensure that relevant ipso facto clauses in contracts entered into after commencement can only be exercised while the administration or scheme subsists.
Of course, it may be that in the case of companies that enter into a DOCA as a result of the administration process, deed administrators develop a practice of applying for Extension Orders extending the operation of the Automatic Stay under the proposed new section 451E(3), so as to ensure relevant ipso facto clauses cannot be exercised by reference to the earlier appointment of an administrator whilst the company is in and after it emerges from, deed administration. However, in our view, this is a potentially expensive, time consuming and uncertain solution, and also imposes a significant burden on the courts. Our strong preference would be for the draft legislation to be amended such that the Automatic Stay (and thus the potential operation of Stay Orders) is permanent, at least in respect of companies that are successfully restructured via a scheme or a fully effectuated DOCA.
It is also puzzling why under the proposed new section 451E(2)(b), the legislation’s drafters appear to be insisting that Extension Orders can only be applied for “within 7 days after” a DOCA is executed, whereas section 444F Orders (which are a prerequisite for an Extension Order) can be applied for by administrators (after the second creditors’ meeting until the DOCA is executed) and deed administrators (after the DOCA is executed). In our view it would make sense for administrators and deed administrators (as relevant) to be able to apply for Extension Orders and section 444F Orders in a single application after the second creditors meeting. We note this appears to be the intention of section 451E(3)(c), notwithstanding the reference to “after” in section 451E(2)(b).
In our view, further consideration should also be given to merits of extending the:
- Automatic Stay to receivership and DOCA triggered ipso facto clauses; and
- Stay Orders to contractual rights where the court is convinced such rights are only being exercised, might be exercised or there is a threat that they might be exercised, merely because the company is in receivership or subject to a DOCA.
Public submissions on the draft legislation are due 24 April 2017. Gilbert + Tobin will provide further updates as the legislation is finalised.
Copies of the Treasury’s Media release, the Exposure Draft Bill, the Explanatory Memorandum and the abovementioned Explanatory Note can be found on the Department of Treasury’s website.
If you would like further information, please don’t hesitate to contact us.
 Note that Extension Orders are only available if an order under s444F Corporations Act is already in force for the benefit of the company and the court is satisfied that it is appropriate in the interests of justice for the automatic stay to be extended. Under section 444F, once a company’s creditors have resolved that a company enters into a DOCA, the administrator (until such time as the DOCA is executed) or the deed administrator (once the DOCA is executed) can apply for orders limiting the rights of secured creditors or owners or lessors, such that (a) a secured creditor of the company cannot realise or otherwise deal with its security interest, except as permitted by the order; and (b) an owner or lessor of property used or occupied by or in the possession of the company, cannot take possession of the property or otherwise recover it.
 See Footnote 1