Government support for business ends: directors’ personal liability for insolvent trading to resume

Anchor your business to a safe harbour
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Why you need a business survival plan before Government support for business ends

The COVID-19 pandemic created circumstances so unusual that few businesses had a plan to survive, let alone emerge from it. Many companies which would have entered a formal insolvency procedure, such as voluntary administration, have been surviving on Government support for business. But, when Government support for business ends, will those businesses be able to survive?

This article looks at the Safe Harbour Extension which temporarily suspends directors’ personal liability for insolvent trading until 25 September 2020, and what you, as a director, need to do to protect yourself before personal liability for insolvent trading is reinstated.

What is the Safe Harbour Extension?

Under Section 588G of the Corporations Act 2001 (Cth) (Act), a director can be personally liable to pay debts incurred by a company where:

  • the company incurs a debt while already insolvent, or where the company becomes insolvent due to incurring that debt;
  • there were reasonable grounds to suspect that the company was insolvent or would become so when the debt was incurred; and
  • the director was aware of such grounds, or a reasonable person in a like position in a company would have been aware of such grounds.

In the wake of the coronavirus pandemic, the Government passed legislation creating a Safe Harbour Extension. This effectively temporarily suspended directors’ personal liability for insolvent trading to try to avoid a huge number of companies entering a formal insolvency procedure due to the economic impact of the pandemic.

The new section 588GAAA of the Act (Safe Harbour Extension) protects directors from personal liability for debts incurred:

  • during the six-month period from 25 March 2020, excluding debts effectively incurred before that date;
  • in the ordinary course of business, meaning those debts necessary to facilitate the continuation of the business during the prescribed period; and
  • before the appointment of an administrator or liquidator

The existing safe harbour regime

Even before the Government introduced the Safe Harbour Extension, the law recognised that sometimes, it is better for the company and the company’s creditors that directors keep control of the company and continue to trade through a downturn. To thread this particular needle, the Act contains ‘safe harbour’ provisions that Unlike the Safe Harbour Extension, the existing safe harbour protection was limited because:

  1. directors needed to start developing the plan of action referred to above;
  2. the company must be paying and remain able to pay the entitlements of its employees (wages etc.) by the time they fall due; and
  3. the company must be complying with disclosures required under tax laws, such as the filing of notices and statements.

These are not requirements of the Safe Harbour Extension.

What are the limitations of the Safe Harbour Extension?

Directors should be aware that the Safe Harbour Extension does not give them carte blanche to do whatever they choose. Some decisions may fall outside the Safe Harbour Extension, and directors may find themselves liable after the fact.

Directors must still comply with all the provisions of the Act and with their common law duties. Among those duties, directors must:

  • act with the degree of care and diligence that a reasonable person might be expected to show in the role (s180 of the Act). Directors may breach this duty if they cause a company to enter into risky transactions without any prospect of producing a benefit for the company;
  • act in good faith, in the best interests of the company and for a proper purpose (s181 of the Act); and
  • not improperly use their position to gain an advantage for themselves or someone else, or to the detriment to the company (s182 of the Act).

Taking a responsible approach towards navigating your company out of COVID-19 hibernation (or whatever coping mechanisms you have put in place) is part of these duties.

What does this mean in practice?

Be particularly careful about incurring debt

While the Safe Harbour Extension protects directors against personal liability for insolvent trading, it only applies to debts incurred ‘in the ordinary course of business’. As anyone running a business during the COVID-19 pandemic will tell you, the ‘ordinary course of business’ is currently anything but.

In the Explanatory Memorandum  to the legislation enacting the Safe Harbour Extension, the Government stated that:

“A director is taken to incur a debt in the ordinary course of business if it is necessary to facilitate the continuation of the business during the six-month period”. 

However, if your company ends up in liquidation despite your best efforts, be prepared for close scrutiny of those debts. Whether they are considered to be ‘in the ordinary course of business’ will depend on the facts of each case.

If your business is in trouble, don’t wait to take action

While it may be tempting to take advantage of the temporary measures in place and adopt a ‘wait and see’ strategy, doing so puts your company at serious risk. By the time the relaxation to personal liability is lifted, your business may have exhausted its asset base — not to mention the goodwill of its creditors – and you may have no choice but to enter the winding-up process.

It is therefore very important that directors take reasonable steps now to inform themselves of their company’s financial situation and future viability. To continue to act in the best interests of the company, timely action to bridge the gap between the current and future situation is critical.

Indeed, waiting may constitute a breach of your duties to act with care and diligence, and in the best interests of your company.

So what can directors do now?

Be realistic about whether your business can survive post-COVID

If your company is surviving due to JobKeeper subsidies, the forbearance of creditors and the higher threshold for issuing a statutory demand and waiting time before winding-up action can be taken, it’s time to sit down and be realistic about its chance of survival.

Some companies can anticipate a ‘snap back’ once restrictions are lifted. Gyms, hospitality venues and beauty salons are among those who couldn’t operate at all and are still limited as to how many customers they can welcome, but may have a robust business model underneath.

Others, like tourism and tertiary education businesses who are heavily reliant on foreign visitors, may struggle for several years. It has been suggested that Australia will experience years of recession, meaning that retailers offering discretionary goods and services may also be in trouble.

If you can be honest with yourself now, you can face the future with a clearer head and a realistic plan.

Weigh the pros and cons of pressing on

COVID-19 is a global pandemic and every country’s response is different. Its ramifications are so far reaching that it is almost impossible to predict what the economic landscape will look like in one, two or even ten years hence.

In these circumstances, the director of a company which is already finding it difficult to meet its outgoings, and whose revenue is down, faces a huge question. By deciding to press on, is a director acting with due care?

Unhelpfully, the answer is: it depends on the result.

If the directors decide to press on, the economy improves and the company recovers, nobody would argue that they acted without due care.

However, if they press on and the company fails, they risk losing the chance to enter voluntary administration and instead may end up in immediate winding-up proceedings.

In this circumstance, liquidators may question whether the decision by the directors constituted ‘due care’ and try to hold the director personally liable.

This is particularly risky if trading on necessitated the incurring of further debt or selling off company assets, because these actions may materially worsen the position of creditors when the company does enter winding-up proceedings.

In a third scenario, directors may choose not to press on. They might choose instead to commence winding-up proceedings and end the business. In this case, the risk is that shareholders will allege that the company would have survived (especially if there is a ‘snap-back’ or v-shaped recovery) and that by winding-up, directors have abandoned their duties to act in the best interests of the company.

This is a delicate balancing act. However, there are things you can do to mitigate the risk.

What practical steps can directors take now to be prepared for September?

Create a written financial plan

One thing that directors can do is to create a written business plan, well supported with realistic financial projections. Even if you are found to have failed in your duties, the court may be able to excuse you if it considers that you have acted honestly and in good faith. A written and thoroughly laid out plan, especially against the background of a once-in-a-lifetime crisis, may support your defence in these circumstances.

Review all aspects of your business

The company’s bank balance is only one part of the story. Consider also whether:

  1. Your suppliers are likely to experience ongoing disruption and, if so, will the cost of materials go up in price?
  2. Your overheads can be cut. Many businesses who don’t need customers to come to them are looking at whether their workforce can work from home so they can save on real estate costs, for example.
  3. Your business model is sustainable as it is, or if you need to pivot. If so, will you need to raise capital or incur debt?
  4. There are any existing contractual obligations with suppliers or customers that you can’t fulfil due to COVID-19? If so, a force majeure clause may assist you but it’s wise to seek legal advice now and avoid protracted negotiations down the track or wrongly assert force majeure which may open you up to a claim.

Get professional advice

Timely advice from an insolvency expert can help you develop a stronger plan for the future. They will be able to discuss the various options with you and even suggest alternatives you may not have thought of.

If you are challenged in the future about your decisions at this critical time, evidence that you sought expert advice may put you in a stronger position.

Is voluntary administration the right path?

If your company is weighed down by debt, with poor prospects for a return to previous revenues, you may already be a ‘zombie business’. It can be a hard truth to face, but if the subsidies and other lifelines offered by the Government are the only things keeping your business afloat, you might need to consider entering voluntary administration.

Appointing administrators earlier rather than later has several advantages beyond the ability to avoid personal liability for insolvent trading. Administration can be a strategic move that allows the company to restructure its liabilities and capital and improve its financial position and survival prospects.

For more information about voluntary administration, click on this link.

What you should do now?

The decisions you make about your company now will determine whether it is sustainable in the future. As a director, you have a duty to act with due care, skill and diligence, and to act in the best interests of the company. These duties have not been modified by the Safe Harbour Extension.

Remember, generally speaking, the longer you wait to develop a strategy for your business’s survival, the fewer viable options you may have.

For that reason, it is crucial that you seek advice early if your company is facing a possible insolvency. A qualified independent advisor can help you understand your financial position and the options available to you going forward – this may mean docking in a safe harbour.

Further information

For more information about how to prepare your company for the end of the safe harbour regime extension, please contact:
Trevor Withane: trevor.withane@blackwattlelegal.com.au, tel +61 (0)418 717 001

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