The COVID-19 safe harbour: a shelter in the storm for directors?

The COVID-19 safe harbour provides some breathing-room for directors of companies in trouble – but the relief is time-limited and the clock is ticking, according to UNSW Business School's Pamela Hanrahan and Anil Hargovan

Treasurer Josh Frydenberg’s July economic and fiscal update confirmed what most have known for a while – that the COVID-19 pandemic has caused a serious economic contraction and that there remains significant uncertainty around the global and domestic recovery.

All businesses will have to adapt and inevitably some will not survive. Schumpeterian notions of creative destruction are little comfort to directors and managers faced with a business model that collapsed overnight and no clear sense of when normal trading conditions might return. The realisation is dawning on some that keeping their business on life-support – in the form of government support and stimulus payments – may not be in the best interests of the owners, employees or creditors as measures like JobKeeper are wound back and their sector’s post-pandemic future is uncertain.

Australian directors face the further headache of potential personal liability for insolvent trading in these circumstances. Section 588G of the Corporations Act 2001 (Cth) means directors may be on the hook if debts are incurred when there are reasonable grounds for suspecting that their company is insolvent. Subsection 588G(2) is a civil penalty provision, which means that a director can face penalties exceeding $1,000,000 if they knew or ought to have known that there were grounds for suspecting insolvency when the debt was incurred and failed to prevent it. This liability is in addition to directors’ personal responsibilities through the tax system for unpaid PAYG instalments and GST and SGC contributions.

Directors can avoid this risk by reading the writing on the wall and, if the company’s prospects are bleak, taking steps to bring in the administrators. But what if there are signs the business can be salvaged? That’s where the statutory safe harbours potentially come in.

The COVID-19 safe harbour

On 25 March 2020, the Commonwealth government temporarily suspended aspects of the insolvent trading law, by creating a six-month safe harbour for debts incurred ‘in the ordinary course of the company’s business’, with the option for the government to extend the period if needed. Similar measures were adopted in Singapore and the United Kingdom.

Section 588GAAA, contained in Schedule 12 to the Coronavirus Economic Response Package Omnibus Act 2020 (Cth), suspends the operation of the civil penalty provision in s 588G(2) for the duration. However, it does not affect the operation of s 588G(3) of the Act, which continues to make the dishonest failure to prevent the company incurring debt in these circumstances a criminal offence. Prison terms for former directors of Kleenmaid for fraud and criminal insolvent trading are a reminder that the consequences of dishonest conduct can be severe.

The COVID-19 safe harbour provides some breathing-room for directors of companies in trouble, but not much. First, the legislation puts the onus on directors to prove that any new debt was incurred in the ordinary course of business, which is not defined and may be hard to demonstrate in these ‘unprecedented’ times. Second, it does not relieve directors of their other core duties, including to act with care and diligence, in good faith and in the best interests of the company – which includes paying attention to the interests of creditors. 

Third, the relief is time-limited and the clock is ticking. Given the anticipated surge in insolvencies when the support and stimulus programs end, it is essential for boards to continuously monitor and assess the company’s financial performance and take timely remedial action when warranted. Failure to pay ongoing attention to the financial health of the company, due to a false sense of security, will potentially expose directors to the full brunt of the punitive insolvent trading laws after the COVID-19 safe harbour period ends.

The ‘workout’ safe harbour

The word around town is that many businesses – large and small – are instead looking closely at the existing workout safe harbour. This regime, which was created in 2017 and sits in s 588GA of the Act, provides a safe harbour from s 588G(2) for directors who are engaging in a course of action reasonably likely to lead to a better outcome for a company in trouble than an immediate liquidation or administration.

Like most of the Act, the drafting of s 588GA is convoluted. But in essence, a director can rely on the safe harbour if they can prove the debt was incurred, during a relevant window, in connection with any course of action being developed as reasonably likely to lead to a ‘better outcome’ for the company. The window opens when the director ‘starts to suspect the company may become or be insolvent’ and ‘starts developing’ the course of action, and closes, among other things, when ‘any such course of action ceases to be reasonably likely to lead to a better outcome for the company’.

The intention is to encourage responsible boards, assisted by qualified professional advisers, to remain in control of a company in financial difficulty, explore turn-around strategies, and take reasonable steps to restructure the business or allow it to trade out of its difficulties. The fact that boards are working with advisers, and therefore potentially covered by the work-out safe harbour, is unlikely to be public knowledge.

The safe harbour is not an invitation for magical thinking. In showing their plans were reasonable, directors may need to prove that they were properly informed of the company’s financial position and taking appropriate steps to ensure that the company was keeping appropriate financial records. 

It will also be relevant whether the board was obtaining advice from an ‘appropriately qualified entity who was given sufficient information to give appropriate advice’, and was ‘developing or implementing a plan for restructuring the company to improve its financial position’.

Boards need to be aware that the safe harbour provisions are easier to state than to apply. This is due to uncertainty in the framing of the statutory requirements and the fact that these provisions are largely untested in the courts. Also, failure to pay employee entitlements and to keep proper books and records disentitles reliance on the safe harbour.

Despite these uncertainties, many prudent boards are now quietly considering engaging a lawyer or insolvency practitioner for professional guidance and to ensure that any rescue plan that emerges passes muster.

As the Explanatory Memorandum to the 2017 legislation made clear, ‘hope is not a strategy. Directors who merely take a passive approach to the business’s position or allow a company to continue trading as usual during severe financial difficulty, or whose recovery plans are fanciful, will fall outside the bounds of the safe harbour’. And ‘directors who fail to implement a course of action, or to appoint an administrator or liquidator within a reasonable time of identifying severe financial difficulty, will also lose the benefit of safe harbour’.

Despite these limitations, the safe harbours are there to assist honest and diligent boards working through the current challenges, and awareness and a bit of forward-planning may make all the difference down the track.

For more information please contact Anil Hargovan or Pamela Hanrahan.