On Improving Bankruptcy and Insolvency Laws – Safe Harbours and Unenforceable Ipso Facto Clauses when Restructuring Companies?

by Andrew Lind on 3 July, 19

Earlier this year, the Australian Government called for submissions on its Improving Bankruptcy and Insolvency Laws Proposal Paper as part of its National Innovation and Science Agenda. The Government expressed a willingness to legislate on introducing “safe harbour” provisions for directors of companies nearing insolvency, as well as nullifying “ipso facto” clauses where the enforceability of such clauses would hinder the restructuring process.

The proposals, should they result in reforms, will be particularly relevant to business owners encountering or faced with liquidity problems.

The Rationale Behind the Proposals

The Australia Government noted that:

“More often than not, entrepreneurs will fail several times before they achieve success. To create an ecosystem that enables these entrepreneurs to succeed will require a cultural shift. Our current insolvency laws put too much focus on penalising and stigmatising the failures. With these measures in place, bankruptcy and insolvency laws will strike a better balance between encouraging entrepreneurship and protecting creditors. Over time, these changes will help reduce the stigma associated with business failure.”

A comparison can be drawn to the Chapter 11 Bankruptcy scheme in the United States which places value on restructuring companies, rather prioritising the interests of creditors.

What are the proposals?

The Government proposed to improve the insolvency laws by:

“1. Introducing a ‘safe harbour’ for directors from personal liability for insolvent trading if they appoint a restructuring adviser to develop a turnaround plan for the company; and

  1. Making ‘ipso facto’ clauses, which have the purpose of allowing contracts to be terminated solely due to an insolvency event, unenforceable if a company is undertaking a restructure.”

It has been proposed that these changes will help facilitate businesses restructuring during financial difficulty, while also encouraging entrepreneurship and removing the stigma of business failure.

‘Safe Harbours’ for directors from personal liability for insolvent trading, subject to appointment of a restructuring adviser to develop a turnaround plan

Pursuant to section 588G of the Corporations Act 2001 (Cth) a director will be held strictly and personally liable and commits an offence where he or she engages in insolvent trading. While this provision was introduced into the legislation to protect creditors, the Australian Government accepted in its proposal paper that:

 “The threat of Australia’s insolvent trading laws, combined with uncertainty over the precise moment a company becomes insolvent have long been identified as a driver behind companies entering voluntary administration, even in circumstances where the company may be viable in the long term.”

The Government also noted that the threat of insolvent trading is why directors and angel investors are also unlikely to invest into start-up businesses.

By potentially introducing safe harbour provisions, the Government aims to strike a better balance between encouraging company restructuring and protecting creditors.

The Australian Government introduced two models by which to provide safe harbour to directors.

Safe Harbour Model A

The first model proposes that the following defence to section 588G be implemented:

“It would be a defence to s588G if, at the time when the debt was incurred, a reasonable director would have an expectation, based on advice provided by an appropriately experienced, qualified and informed restructuring adviser, that the company can be returned to solvency within a reasonable period of time, and the director is taking reasonable steps to ensure it does so.

The defence would apply where the company appoints a restructuring adviser who:

(a)   is provided with appropriate books and records within a reasonable period of their appointment to enable them to form a view as to the viability of the business; and

(b)   is and remains of the opinion that the company can avoid insolvent liquidation and is likely to be able to be returned to solvency within a reasonable period of time.

The restructuring adviser would be required to exercise their powers and discharge their duties in good faith in the best interests of the company and to inform ASIC of any misconduct they identify.”

The Australian Government noted that such a provision would allow for a “restructuring option” free from the threat of strict liability, and without having to surrender control of the company to an external administrator.

In qualifying this, the Safe Harbour defence would not be extended to directors without good corporate governance or who had breached their director’s duties.

Role of Restructuring Advisers

The role of the restructuring advisor would be to assess whether or not a company is “viable” for potential restructuring, instead of placing the company into voluntary administration. The Government invited suggestion as to who should be eligible to register as a restructuring adviser.

Safe Harbour Model B

The second model carves out section 588G in providing that,

“Section 588 does not apply:

(a)    if the debt was incurred as part of reasonable steps to maintain or return the company to solvency within a reasonable period of time; and

(b)    the person held the honest and reasonable belief that incurring the debt was in the best interests of the company and its creditors as a whole; and

(c)   incurring the debt does not materially increase the risk of serious loss to creditors.”

This model does not include the introduction of a restructuring adviser. In this situation, the onus would be on the liquidator to bring a claim to show that a director has breached any one of the three limbs of the provision.

 The Voiding of Ipso Facto Clauses

The Australian Government also proposed to legislate to void “ipso facto” clauses in contracts with turnaround companies. Commonly, “ipso facto” clauses allow one party to terminate a contract where the other party is guilty of an insolvency event.  These clauses (for example in the context of supply contracts) may also allow the innocent party to amend the contract, which can make it difficult for businesses in financial difficulty to operate effectively.

The Australian Government hopes that by limiting the impact of “ipso facto” clauses, companies facing liquidity issues will avoid having the value of the business being diminished, which in turn may improve the prospects of a successful restructure or sale of the business as a going concern.  This impacts the return to creditors in the long term should the company fall into liquidation after an unsuccessful attempt to restructure.

Outcome

Submissions to the Australian Treasury closed at the end of May 2016.  The Australian Government has not issued any response in relation to the feedback received and it remains to be seen whether these proposals may be the newest reforms in the Australian Insolvency landscape after the recent introduction of the Insolvency Law Reform Act 2016 (Cth) set to take effect in March 2017.

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