Arriving in Safe Harbour?

Legislation to implement the Safe Harbour and ipso facto protections was tabled in Parliament today, reflecting a rapid progression from the exposure draft released on 28 March 2017.

The legislation includes some adjustments to the original safe harbour proposals, and very significant and sensible changes to the original ipso facto protection proposals.

Those responsible for the drafting should be commended for the care that they have taken to avoid unintended consequences.

The Safe Harbour protection

The Safe Harbour reform is intended to address a concern that the risk of potential insolvent trading claims was forcing directors to place their companies into administration prematurely, rather than try to restructure them. There are those who will say they have never actually seen a premature administration – but we should not let that objection overshadow the fact that the reforms will certainly lead some directors to take better advice and a more systematic approach to a turnaround, and that has to be a good thing.

Technically the safe harbour protection is a ‘carve-out’ from the insolvent trading liability provisions and not a defence. However, many will think of it as a defence, because it provides a practical and useful checklist of issues that company directors need to address to ensure that they are not caught by an insolvent trading claim for debt. Notably, it provides protection only for debt incurred in connection with a course of action ‘reasonably likely to lead to a better outcome,’ and the protection ceases if that course of action ceases.

Well advised directors will create a document, probably specifically identified as a ‘Restructuring Plan,’ that will set out:

An objective – preferably a return to solvency or viability, but if not, the ‘better outcome’ that the legislation requires. If it is a ‘better outcome objective, then presumably there will be an analysis comparing the planned outcome to the expected return from an immediate liquidation.
The steps that the directors have taken to ensure that they have taken advice from an appropriately qualified and properly informed adviser.
The reasons why the directors are able to conclude that they are properly informed about the financial position of the company, and what they will do to ensure that they remain properly informed.
The steps that the directors will be taking to ensure that there will be no misconduct ‘that could adversely affect the company’s ability to pay all its debts.’
The reasons why the directors are able to conclude that the company is keeping appropriate financial records, and how they will ensure that continues.
A set of actions to deliver the objective, to be undertaken by or under the supervision of the directors.
The process by which the directors will measure the effectiveness of the actions and review the plan to ensure that it continues to meet the safe harbour requirements. Presumably there will be formal milestones, and a series of monthly (or more frequent) reviews involving the adviser if he or she is not directly involved in the turnaround.

The legislation does not provide any guidance as to what constitutes an ‘appropriately qualified’ adviser. The explanatory memorandum says that the question is not ‘limited merely to the possession of particular qualifications,’ and references:

independence
professional qualifications
membership of appropriate professional bodies
professional indemnity insurance to cover the advice being given.

Those well advised directors will likewise avoid falling foul of the disqualifying criteria, by:

Paying employee entitlements as they fall due.
Keeping tax returns and lodgements up to date.
Submitting a Report as to Affairs in the event that the plan fails and the company later passes into formal insolvency administration.

Although the Court will have the discretion to excuse a disqualification, that will occur only in ‘exceptional circumstances’ or where it is ‘otherwise in the interests of justice,’ so clearly it would best to not have to make such an application!

Arguably the most significant development over the exposure draft proposals is an extension to now also provide a similar protection to the holding company of an insolvent subsidiary.

The safe harbour protections apply in respect of debt incurred after the commencement (the day after the amending Act receives Royal Assent) but take into account actions taken before commencement, which means that there will be no need for directors to reconfirm an existing restructuring plan on commencement.

Ipso Facto protection

A wide range of commercial contracts including franchise agreements, leases, licenses and supply agreements will include a clause that allows one party to terminate the agreement if the other party becomes insolvent – even if there is no other default.

Such ipso facto clauses mean that a business is at risk of disintegration if there is a formal insolvency appointment – at the very time when it is essential to try and maintain it as a going concern, to ensure ongoing employment for staff and the best return for creditors.

To address this, the reform proposals included a stay mechanism that would prevent the operation of such clauses. Whilst the exposure draft included a carefully defined and limited stay that would have had a very limited impact, pleasingly, the final version includes a considerably broader stay:

The stay will now also offer protection where a managing controller has been appointed – so long as the appointment is over ‘the whole or substantially the whole of the assets of the business.’
Perhaps most significantly, the stay will also provide far greater protection, against termination based on the ‘financial condition’ of the company, with scope for further expansion of the protection by regulation.
For Schemes of Arrangement the stay will commence when a public announcement is made, rather than require the actual formal commencement of an application.

There have been other very significant changes:

Critically, a contractual right to terminate will be indefinitely unenforceable – even after the end of the stay. This very important amendment means that an ipso facto clause will no longer provide the other party to the contract with a free option to terminate the contract at will.

The stay will not prevent a secured creditor from appointing a receiver after an administrator is appointed. Whilst this may appear at odds with the purpose behind the stay, it is important because will eliminate a potential ‘first mover advantage’ that might otherwise have prompted secured lenders to seek a premature insolvency appointment.

The ipso facto stay will apply to rights arising under contracts entered on or after the commencement (i.e. 30 June 2018 unless there is an earlier proclamation). Start-ups incorporated after that date will therefore have the full benefit of the changes. Disappointingly, companies trading today will not receive ipso facto protection, unless they change suppliers or enter into a completely new contract.

Restructuring Reforms: Safe Harbour and ipso facto

On 28 March 2017 the government released draft legislation for comment, to implement the Safe Harbour and ipso facto reforms, available here.

Safe Harbour proposal – simple, practical and useful

The Government has opted for a carve-out from the civil insolvent trading provisions – a ‘model B’ approach.

Directors will have a ‘safe harbour’ unless it can be shown that they had failed to start a course of action “reasonably likely to lead to a better outcome for the company and its creditors as a whole.”

That immediately raises the question: how will we know whether a course of action is reasonably likely to lead to a better outcome? Helpfully, the draft legislation set outs what amounts to a checklist for directors, as to whether they are:

taking appropriate steps to prevent misconduct that could affect the company’s ability to pay all its debts.
taking appropriate steps to ensure that the company is keeping appropriate financial records.
obtaining appropriate advice from an appropriately qualified person holding enough information to give appropriate advice.
is properly informing themselves of the company’s financial position.
is developing or implementing a plan for restructuring the company to improve its financial position.

There is disqualifying criteria: if the company is fails to provide appropriately for employee entitlements, or fails to attend to its obligations to lodge income tax returns or other tax lodgements then the safe harbour is not available – so we can add those to the checklist too.

Ipso Facto – Linkage to an appointment type rather than a state of insolvency?

The draft legislation provides a very precisely phrased stay, which blocks termination on the grounds of two specific types of formal insolvency appointment: voluntary administration and schemes of arrangement.

The legislation is silent about a termination on the grounds of insolvency. There is an argument that a termination on the grounds of insolvency – which is actually evidenced by the appointment of an administrator – is unaffected by the stay.

Termination at will remains

The implementation of a stay on ipso facto clause enforcement will make it easier for a voluntary administrator to keep a business together – an enhancement over and above the current moratorium – by preventing the termination of contracts simply by reason of the appointment. But the stay will end when the administration ends, meaning that the underlying insolvency event will provide the other party to the contract with a free option to terminate the contract at will. Knowing, for example, that a landlord will be able to terminate a lease if they ever receive a better offer will make it challenging to raise finance, secure equity or sell a business.

The better option would be to make the stay permanent, or introduce some kind of override so that if the insolvency has been cured by a restructuring, then it can no longer be relied upon for the purposes of an ipso facto clause enforcement.

Extension to schemes of arrangement

In a theoretical sense the extension of the ipso facto stay to Schemes of Arrangement is significant, because unlike voluntary administration there was no moratorium. In practice however this change will have little impact, because schemes are so slow and so hideously expensive that they are used only infrequently, to restructure the very largest companies.

No ipso facto stay for receiverships

The proposals do not extend the ipso facto stay to receiverships. Secured creditors will consider whether it is possible to access the stay by the parallel appointment of an administrator, just as they do now to access the voluntary administration moratorium, but [as Paul Apathy has pointed out] this may not be viable. A better option would be a stay which applies to insolvency rather than nominated appointment types. Not only would that apply the benefit of the stay to all forms of appointment type, it would avoid an argument that termination on the grounds of insolvency was unaffected.

Impact on a secured lender’s ability to appoint a receiver

In the 2015 NSW Supreme Court Bluenergy decision, discussed in more detail here the Court held that a deed of company arrangement limits a secured creditor’s security to those assets existing when the deed took effect – which means that the charge will no longer capture “future assets” (such as the receivable that is created when stock is sold).

As a result, the assets captured by a secured creditor’s security will steadily diminish over time. Currently, secured creditors can avoid the risk of diminution by appointing a receiver when a voluntary administrator is appointed, but they must do so within the 10 day decision period set out in section 441A.

The proposals appear to stop secured creditors making such appointments if relying solely on the grounds of the appointment of a voluntary administrator.

Secured creditors concerned that there is a risk that their security is trapped within a deed of company arrangement may decide that it is in their interests to:

Decline to waive defaults, so that they will not need to rely on an insolvency event to make an appointment
Take care not to alert borrowers that an appointment is possible
Seek to appoint receivers at an earlier stage, to avoid the risk that directors might “beat them to” an appointment.

In other words there is risk that measures intended to promote restructuring may provide secured lenders with reasons to refuse to waive defaults, be cautious about communicating their concerns, and appointing receivers at an earlier time.

Ipso facto commencement

It is proposed that the stay will apply only to contracts entered into after 1 January 2018. It will therefore operate fully for businesses that start up after that date, but for existing businesses there may be a very gradual transition.

Overall

The draft legislation has appeared earlier than expected, with a short timetable for implementation – it is proposed that the new laws will take effect from 1 January 2018 – which is welcome. My view is that the safe harbour mechanism is very useful and very practical. The ipso facto regime has great potential, but there are a number of issues requiring further consideration and analysis, most notably the closing the gap which currently provides counterparties with a free option to terminate at will – even after insolvency has been cured.

The closing date for submissions on the proposals is Monday, 24 April 2017.

The National Innovation Agenda – improving Australia’s bankruptcy and insolvency laws

[First published on Linkedin.com on May 24, 2016]

On 29 April 2016 the Federal Government released a Proposals Paper which follows up on the National Innovation Agenda commitment to improve Australia’s bankruptcy and insolvency laws.

There are three areas of focus:

Reducing the default bankruptcy period from three years to one year

The proposal is more nuanced than a simple reduction in the bankruptcy period. Critically, the Income Contribution regime will continue to apply for three years i.e. potentially for two years after the bankruptcy itself has ended. However, there would be no restrictions on overseas travel or incurring credit after the initial twelve month period had expired.

The trustee will retain the ability to object to the bankrupt’s automatic discharge – thereby extending the period of bankruptcy to eight years – but it appears that it would be necessary to file that objection in the initial twelve month period. Such a change will mean that trustees need to accelerate their investigation to ensure that misconduct is identified before the initial period expires. It may also mean that in the last two years trustees must collect information and contributions without the benefit of what is currently an inexpensive and practical avenue to ensure compliance.

Safe Harbour

The current insolvent trading regime imposes personal liability on company directors if their company incurs credit whilst it is insolvent. The practical effect of the regime is that it provides a strong incentive for company directors to place an insolvent company (or a company that may become insolvent) into administration – even though a restructure might offer the prospect of a better return to creditors.

The proposal outlines two alternative methods of dealing with that statutory conflict of interest. The first approach – Model A – will create a “safe harbour” by establishing an additional defence to the current insolvent trading regime, whereas Model B will create a safe harbour by identifying circumstances in which the insolvent trading regime will not apply. Probably more significantly, Model A requires the directors to formally engage a “restructuring adviser,” whereas Model B does not.

My own experience with large corporate turnarounds is that the range of issues can be very broad – from balance sheet restructure to operational turnaround – and that in many cases there will be a team of advisers assisting the directors rather than a single person. I believe that the focus should be on what the directors do, rather than whom they appoint,

A process that requires the appointment of a restructuring adviser will almost certainly trigger the rigorous continuous disclosure requirements that apply to ASX listed companies. This will present additional challenges in a restructuring because publicity about possible financial difficulties can become self-fulfilling as suppliers rein in credit terms, and customers take their business elsewhere. For this reason it is important that any Model A approach also includes a prohibition on disclosure, otherwise there is the risk that directors of ASX listed companies will not take advantage of the safe harbour.

Ipso facto clauses

Ipso facto or insolvency event clauses allow contracts to be terminated if there is an insolvency appointment, even if there is no other breach of the contract.

In my view, restricting the operation of ipso facto clauses is the most significant of the proposed reforms because it will make it far easier for administrators and receivers to maintain a business as a going concern without losing the benefit of key contracts

It is essential that the restriction be permanent rather than a temporary stay (which in any event is the current position for voluntary administration), otherwise there is the risk that the clause can be invoked even after the insolvency has been ‘cured’ by a restructuring.

One of the key questions is whether the restriction on ipso facto clauses would operate to prevent a secured lender from appointing a receiver. Lenders will often waive defaults under loan agreements in the knowledge that the insolvency ground will provide a ‘reserve’ capacity to act. If the ipso facto restriction eliminates that reserve capacity, then secured creditors may be less willing to waive defaults – which would be problematic for both directors and auditors. Clearly I have an interest in this point, but it would be disappointing if a law reform intended to encourage restructuring instead had such an effect

The government is seeking feedback by Friday 27 May. I encourage everyone with an interest in the area to read the Proposals Paper and respond on points that concern them. For more information: see here.