Why are so few directors seeking a safe harbour?

The new insolvency provisions are yet to make an impact

It is more than a year since Australian company directors gained access to a 'safe harbour', protecting them from liability for insolvent trading, but it is unclear how well the new laws work.

For Australian company directors, insolvency has traditionally come with a high price.

Not only have directors potentially faced the loss of their employment and funds invested in the company, and – in some eyes at least – suffered the ignominy of steering a failed enterprise, they could also be held personally liable for any debts the company ran up while insolvent.

It was amid growing concerns the existing law was making directors too risk averse and too likely to put a company into administration, even if there was a chance the company could be saved, that the government moved to reform what were considered to be among the harshest insolvency laws in the common law world.

And so, from September 18 last year, directors gained access to a safe harbour from personal civil liability for insolvent trading.

The safe harbour amendment to the Corporations Act states that personal liability does not apply "if at a particular time after the person starts to suspect the company may become or be insolvent, the person starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company; and the debt is incurred directly or indirectly in connection with any such course of action during the period starting at that time".

Directors are excluded from the safe harbour if their organisation hasn't paid all of its employee entitlements or hasn't kept up-to-date records.

Rescue culture

While the law was widely welcomed by company directors and the broader business community, it doesn't appear to have been widely used.

As a result, says Anil Hargovan, an associate professor in the school of taxation and business law at UNSW Business School, it's hard to know exactly how the law will operate because it hasn't yet been tested in court.

"Without judicial interpretation, it's up in the air as to what the provisions mean and how they're meant to operate," he says.

"The best we can do at this point is to rely on anecdotal evidence, and the anecdotal evidence will suggest that it shouldn't be seen as a panacea for promoting corporate rescue or corporate rescue culture because its success is going to be contingent on many things."

Hargovan says one reason for only minimal use of the provision thus far may be lack of awareness and another could be the issue of cost.

Most businesses seeking the protection of the safe harbour will get advice from an accountant or insolvency practitioner, and for a small business that is already short of funds, the cost can seem prohibitive.

While business owners and directors could theoretically make their own judgment about whether they would apply, most are too concerned about the possibility of getting it wrong and facing personal liability for the debts.

'Without judicial interpretation, it’s up in the air as to what the provisions mean and how they’re meant to operate'

- ANIL HARGOVAN

"We do live with a very litigious environment and I guess you want some kind of assurance more than anything else. You want comfort," Hargovan says.

A key difficulty is for directors to know whether or not they are actually in the safe harbour. There is no official stamp or register – it all comes down to a matter of judgment.

"It's very easy to state the legal test and the legal definition for insolvency but to recognise it is another issue because insolvency is not often black and white," says Hargovan.

On top of that is a big question posed by the amended legislation where it requires a course of action that is reasonably likely to lead to a better outcome. What is reasonably likely? What's a better outcome?

"This is an evaluation exercise. You've got to compare with what would have happened if there was an immediate voluntary administration, appointment, or liquidation," says Hargovan.

"But the devil is going to be in the detail. Until we have a case, it's hard to know for certain how much is required."

Breathing space

Matt McGirr, a policy advisor in corporate law and corporate governance at the Australian Institute of Company Directors, says it is appropriate that there is no official recognition that a company is in the safe harbour.

Aside from the practical difficulty, the AICD believes that directors should be encouraged to make their own decisions about what is best for their company.

"Directors who want to access the safe harbour need to be confident that their plan is a good one. What we're asking of directors is a tough thing to do, but it's the right way to go because directors are essentially the custodians for the shareholders and the business," McGirr says.

By reducing the likelihood that directors will tip a company into administration based on their fear of liability for insolvent trading, the safe harbour law should instead ensure they make decisions based on what is in the best interests of the company and the creditors, McGirr says.

While much discussion of the new law focuses on helping directors keep companies out of administration, McGirr points out that there are times when administration may be the best option, either immediately or, for example, in six months when the company is in a stronger position.

"We wanted to give a bit more breathing space for directors so that they could make a good decision," he says.

'In order to get a restructuring plan up and running, you need a whole range of stakeholders to come to the table to agree’

- JOHN MOUAWAD

Another stated aim of the safe harbour laws was to promote a culture of innovation and entrepreneurship, and in this, McGirr expects the law will be a success.

"In the start-up economy, often you'll find that companies struggle with cash at the beginning phase or in their first growth phase and the safe harbour provision will provide some breathing space and not put their companies into administration too early," he says.

The law is also important in sending a message to directors that it's OK to be in financial distress, but that they have to think about what they need to turn that company around.

'Occasional cases'

John Mouawad, executive director at KordaMentha Restructuring, says the firm has only dealt with a handful of insolvencies where the safe harbour provisions were invoked while directors tried to work through a rescue plan.

"Ultimately, the business was in such a dire predicament, the safe harbour wasn't really protecting anyone other than the directors and the company had to go into voluntary administration in any event," he says of one engagement.

Mouawad is unsure how often the provision will save a business that directors might otherwise have put into administration, particularly in larger businesses. He notes that restructures usually require agreement and concessions from creditors and this hasn't changed under the new law.

"In order to get a restructuring plan up and running, you need a whole range of stakeholders to come to the table to agree to the plan because, otherwise, the business will ultimately end up in an insolvency in any event," he says.

"And so, to me, I look at safe harbour as one tool in the director's toolbox, but they need many more tools in the toolbox in order to be able to turn a business around and get it back up on its feet."

When larger businesses are struggling to manage their solvency they are already trying to reach agreement with creditors and other stakeholders about a rescue plan, Mouawad says, and so he questions how much difference the safe harbour rules will make.

Nonetheless, he has seen "occasional cases" where he believes directors put a company into administration when it might otherwise have been saved, because of fear of personal liability.