Looking back and thinking forward: the insolvency landscape in 2022 and beyond – part one

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Financial support for businesses impacted by COVID-19, legislative provisions (such as the statutory relaxation to insolvent trading liability) and general creditor leniency have resulted in historically low insolvency appointments during the last two years. However, as Australia moves away from COVID-19 restrictions and government stimulus programmes are scaled back, the Federal Government is pursuing a new policy towards supporting financially distressed but viable companies to restructure and survive, particularly with regards to small and medium businesses (SMEs).

In this article, we highlight important factors following recent Treasury and Attorney-General consultation papers which may impact insolvency and restructuring in 2022 and the years to come.

In part two of this series, we will consider recent developments in case law from the Federal and High Court on fundamental insolvency principles and their impact on insolvency practice going forward.

Potential legislative changes

The Federal Government is currently exploring options to limit the number of companies entering a terminal insolvency procedure. To this end, Treasury issued a number of consultation papers towards the end of 2021, which respectively considered changes to the insolvency regime to make restructuring easier and more viable.

1. Improved schemes of arrangement (consultation closed 10 September 2021)

Present status: A creditor’s scheme of arrangement enables financially distressed companies to avoid liquidation. It does this through a Court-approved compromise which modifies the pre-existing legal rights of the parties through a binding agreement, which enables the company to continue trading.

Potential changes in store: The consultation paper considered potential changes to the current scheme of arrangement regime, which included the following:

  • Whether to impose an automatic moratorium on creditor’s actions against the company from the time it proposes a scheme of arrangement and if so, how long the moratorium would last
  • Whether to introduce a “cross-class cram down”, essentially a mechanism whereby a scheme of arrangement can be approved by a majority of creditor classes notwithstanding opposition from other creditor classes
  • Whether “debtor-in-possession” finance (a process where creditors providing this finance would be prioritised if the company enters liquidation) should be introduced in Australia
  • Whether the current voting thresholds (majority by number, 75% by value of creditors) to approve a scheme of arrangement is appropriate and if not, what would the appropriate threshold be?

Insight: Although the proposed changes appear significant, it is unlikely there will be increased uptake of schemes of arrangement. This is because these changes do not address the cost-prohibitive nature of schemes of arrangement, which has been the single biggest barrier to SME uptake, which is the demographic most likely to be affected by COVID-19 insolvency issues. Conversely, the imposition of an automatic moratorium might be a boon to legal practitioners as far as litigation is concerned, as perceived breaches to the moratorium will likely arise. Furthermore, creditors might remain hesitant to extend further credit even within a moratorium period, which might harm rather than benefit the operation of the company, opening the door for more disputes.

2. Review of Safe Harbour regime (Final Report tabled in Parliament on 24 March 2022)

Present status: The safe harbour regime introduced in 2017 protects company directors from personal liability for insolvent trading if broadly the company is undertaking a restructure and certain conditions are met. The purpose behind the regime is to give the board the freedom to make decisions relating to a company’s restructuring, which in turn may save viable yet financially distressed companies.

Potential changes in store: The Government has tabled the Review of the Insolvent Trading Safe Harbour Final Report in Parliament, which includes 14 recommendations focusing mainly on improving the wording of the safe harbour provisions and increasing the awareness of those provisions to directors. The most important of those recommendations are:

  • The law should be amended to include a reference to “a person starting to suspect the company is in financial distress” in addition and as an alternative to “a person starting to suspect the company may become or be insolvent”
  • Safe harbour protections should be extended to the obligations of directors to not enter into agreements that avoid employee entitlements
  • A ‘best practice guide’ to safe harbour written in plain English, setting out the general eligibility criteria for appropriately qualified advisers, should be included
  • A finite list of tax reporting obligations (which the company must comply with to utilise the safe harbour regime) should be included
  • Treasury should undertake a full, holistic, in-depth review of Australia’s insolvency laws
  • ASIC Regulatory Guide 217 should be updated to provide straightforward guidance on the operation of insolvent trading prohibitions and safe harbour provisions.
The Federal Government has allocated 0.8 million for the implementation of the recommendations in the Final Review.
 

Insight: The recommendations in the Final Report, if adopted, will bring welcome certainty to the law and improve the accessibility of safe harbour to company directors, particularly with the addition of the simplified ‘best practice guide’ on the eligibility criteria for appropriately qualified advisers. However, this is unlikely to resolve the cost-prohibitive nature of such advice, which in our experience has been the main barrier for SME uptake of the regime. Hence, it is likely that the adoption of safe harbour will continue to be dominated by larger companies at the higher end of corporate restructuring. Although the Final Report is a step in the right direction and may result in some positive impact on the overall insolvency landscape, the magnitude of the impact is likely not going to be significant, particularly with regards to uptake by SMEs.

3. Clarifying treatment of trusts in insolvency (consultation closed 10 December 2021)

Present status: Currently, companies which have a corporate trustee or which are otherwise structured through a trust are not subject to a streamlined statutory process for dissolution in insolvency. Rather, the trust is wound up in accordance with case law and requires directions from the courts, which is a far more time consuming and expensive process.

Potential changes in store: The consultation paper is considering implementing a statutory regime for insolvent trusts akin to that which currently exists for companies that do not use a trust structure. Relevant factors outlined in the paper involve:

  • Whether the following should be codified in legislation:
    • determination of when a trust is insolvent
    • role of the external administrator
    • priority waterfall with regards to an insolvent trust
  • Whether there should be any limit on the enforceability and scope of:
    • ejection clauses (which would automatically remove a trustee if triggered by an insolvent event)
    • indemnity clauses (which would remove the trustee’s right of indemnity in situations of insolvency)

The 2022 budget, released on 29 March 2022, has allocated 7 million to implement these changes.

Insight: The imposition of a statutory regime would bring more certainty in the insolvency process, reducing costs for clients. However, realistically, any attempt to impose a one-size-fits-all framework on a fact-based area of law such as trusts may be untenable, and so any legislative change will likely be very limited in scope. Regardless, any changes in such a contentious area will no doubt lead to more disputes and litigation in the future.

4. Reducing bankruptcy term from 3 years to 1 year (consultation closed 25 February 2022)

Present status: In 2017, the Bankruptcy Amendment (Enterprise Incentives) Bill 2017 was introduced to Parliament, with the purpose of amending the Bankruptcy Act 1966 in order to promote more entrepreneurship and alleviate the stigma associated with bankruptcy. However, the Bill lapsed when Parliament was prorogued in mid-2019.

Potential changes in store: The government remains committed to the Bill, subject to some modifications included in this consultation paper. The main changes are:

  • Reduce the default period of bankruptcy from 3 to 1 year, with exceptions in cases where the bankrupt has already previously been bankrupted or convicted of offences
  • Extend income contribution obligations for discharged bankrupts for a minimum of 2 years after discharge (or in the event of the bankruptcy being extended due to non-compliance, to 5-8 years)
  • Reduce other time periods associated with bankruptcy to 1 year (ie disclosing bankruptcy status while applying for credit; seeking permission for overseas travel; getting certain licenses or entering into certain professions)
  • Extending the default term limit for debt agreements to 5 years
  • Increasing eligibility thresholds for debt agreements and providing that a debt agreement will not be an “act of bankruptcy”
  • Adding more offences to the Bankruptcy Act making it an offence to advise, instruct, assist or counsel any person or attempt to commit the existing offences

Insight: From the business perspective, these changes are a mixed bag – while it may well be that innovation is encouraged as a result of these changes, this is by no means certain. Individuals may choose to take on risks that are imprudent rather than merely calculated and wise risk-taking. However, insolvency practitioners will likely benefit from these reforms. As mentioned, these reforms might have the effect of encouraging individuals to take excessive risks now that the downsides are minimized, which would in turn likely increase activity in the insolvency space. Secondly, trustees-in-bankruptcy are likely to use their power to lodge Notice of Objections to more assiduously discharge their obligations in scrutinising the affairs of the bankrupt, which no doubt will lead to increased legal disputes. Lastly, the addition of more offences will certainly generate more legal activity.

Wrap up

The significant number of zombie companies left behind in the wake of COVID-19 (most of which are SMEs) and the increasingly vocal demands from different stakeholders for an overhaul of insolvency law might give just enough impetus for Parliament to finally enact meaningful changes. The number of insolvency themed consultation papers suggests that the regime is at the forefront of government policy, particularly in relation to SMEs. SMEs remain a critical part of the Australian economy and therefore helping them to restructure following the reduction of government support is vital for economic recovery and growth post-COVID-19.

This is especially true in the light of the upcoming federal elections, with both parties competing vigorously to appeal to small businesses, which has been the demographic most affected by the ravages of COVID-19. This commitment has been clearly demonstrated by the recently released budget (announced on 29 March 2022), the highlights of which were:

  • multiple tax breaks for small businesses engaging in digitisation
  • increasing the Low-and Middle-Income Tax Offset entitlements
  • direct investment of $250 million in “critical minerals” sector

All of this suggests that the government is focused on preserving the status quo of low insolvency appointments. The budget’s inclusion of $30 million in funding for insolvency reform, in particular to implement the recommendations of the Safe Harbour Review above also signifies a real commitment in keeping financially distressed businesses afloat and saving them from going into liquidation.

That said, the prospect of truly meaningful reform remains distant. Many law reform efforts have been made since the Corporate Law Reform Act 1992, but few substantive changes have been made since then. Although the above suggestions are steps in the right direction, we consider they are still lacking because they have yet to address the seminal problem that has so far prevented SME uptake: the issue of cost. 

Further information

For more information about insolvency and restructuring contact Trevor Withane: trevor.withane@blackwattlelegal.com.au, tel +61 (0)418 717 001

Disclaimer

Blackwattle Legal’s communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication.

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