Insolvent Trading Law Reform April 2010 Carl Gunther

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Carl\'s response to the discussion paper on insolvent trading issued by Govt in Jan 2010

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Insolvent Trading Law Reform April 2010 Carl Gunther

  1. 1. Carl Gunther April 2010 On 19th January 2010, the Government announced it was considering making changes to the operation of the insolvent trading provisions. The author discusses the proposals that were put forward and evaluates the arguments for and against reform in this area. Table of contents 1 Introduction:...................................................................................................................... 2 2 Insolvency in the Australian context ................................................................................. 3 2.1 Insolvency defined ................................................................................................... 4 2.2 Director’s duties and insolvency. ............................................................................. 5 2.3 Civil defences to and relief from proceedings of insolvent trading......................... 5 2.4 Informal v’s formal restructuring in the context of Australian insolvency .............. 6 2.5 Safe harbour............................................................................................................. 9 2.6 A case for changing the insolvent trading provisions of the Law ............................ 9 3 Discussion of options....................................................................................................... 10 3.1 Option 1: the case for Status quo .......................................................................... 10 3.1.1 Defences – Section 588 H of the Act. ................................................................ 10 3.1.2 Relief from insolvent trading provision. ............................................................ 11 3.1.3 Summary of the case for Option 1: Status quo ................................................. 12 3.2 Option 2: the case for a Modified Business Judgement Rule ............................... 13 3.2.1 The current business judgement rule................................................................ 13 3.2.2 Proposed modifications to the Business Judgement Rule ................................ 14 3.2.3 Summary of the case for a Modified Business Judgement Rule ?..................... 16 3.3 Option 3 – the case for a Moratorium from the insolvent trading laws?.............. 17 4 Other observations about the Treasury Discussion Paper.............................................. 17 5 Bibliography..................................................................................................................... 19 1
  2. 2. Carl Gunther April 2010 1 Introduction: “I don’t live in fear that I will be found out, but that it will take seven years in the courts to prove it”1 quoted David Gonski, Chairman of Coca-cola Amatil on the matter of personal liability arising from laws with regards to Director’s duties. It’s not the laws themselves that Gonski has a problem with, its the way they are enforced. Personal risks to directors are significant The personal risks to directors associated with seeking to restructure the affairs of a company outside of a formal insolvency are significant. Some commentators suggest the laws in Australia regarding insolvent trading genuinely stifle informal restructuring because of the personal risks. Whilst the likes of David Gonski suggest it’s the way the laws are prosecuted that present the real problem rather than the laws themselves. Treasury Discussion Paper In January 2010, the Minister for Financial Services, Superannuation and Corporate Law, Mr Chris Bowen, announced the release of a discussion paper (Insolvent trading: A safe harbour for reorganisation attempts outside of external administration January 2010) (“Treasury Discussion Paper”) on the operation of Australia's insolvent trading laws in the context of attempts at business rescue outside of external administration. The Minister put forward 3 options as proposals for discussion: Option 1: Status quo- that is no change to the law. Directors need to ensure that their company is solvent whilst undertaking an informal restructuring. 1 Gonski, David Australian Securities Investments Commission Annual Policy Summit Melbourne February 18 2008 2
  3. 3. Carl Gunther April 2010 Option2: Modified business judgement rule: Director’s duty would be satisfied with the application of a prescriptive modified business judgement rule which supplements the requirements of S180 of the Corporations Law. Option 3: Moratorium: A limited moratorium period from the duty not to trade whilst insolvent for the purpose of attempting an informal reorganisation of the company. This paper considers all three options and the arguments for and against. A case for change Having considered in this paper the circumstances of each option, there would appear to be a strong case for changing the insolvent trading laws in a way that supports informal restructuring. A safe harbour approach in the form of a modified Option 2 would appear to be the most appropriate means by which informal restructuring could be implemented. Any changes need to be considered in the context of all stakeholders, not just directors and shareholders. 2 Insolvency in the Australian context The insolvent trading laws in Australia create a defining point at which a company must seek to reorganise its affairs either formally or informally. A formal restructure in this paper is defined as one where the company’s affairs are placed under the control of an external administrator, receiver or liquidator who applies formal reorganisation procedures provided for in the Corporations Act 2001 (“the Act”). An informal restructure is one where the company’s affairs remain under the control of its directors without recourse to the formal reorganisations procedures in the Act. In many cases, the directors will make the decision as to which route to follow and in concluding their decision they will certainly be considering (amongst many factors) their duties and personal liability as it applies under the law. 3
  4. 4. Carl Gunther April 2010 2.1 Insolvency defined The Act defines a person as “insolvent” if they are not “solvent”.2 It further defines a solvent person as one able to pay all of their debts as and when they become due and payable. An insolvent company is therefore a company that is unable to pay all its debts when they become due and payable. The concept of insolvency is derived from legislation and case law precedents. The primary test to ascertain insolvency is applied using a company’s cash flows. Australian courts have also examined certain other commercial and financial issues including the state of a company’s balance sheet when examining whether directors may have been guilty of allowing a company to trade from the time it became insolvent. Whilst a review of case law on the tests of insolvency is beyond the scope of this paper, it is worth noting the following 2 important points: 1 the Courts in considering the meaning of insolvency have stated that “A temporary lack of liquidity does not necessarily mean insolvency”.3 Ultimately directors need to determine if the company’s illiquidity is temporary or permanent. At any point in time, decisions about liquidity will be based upon future outcomes; in a time-pressured environment. Unfortunately the courts judge a director in hindsight once those outcomes are known. 2 An insolvent company is sustained through the funding of the company’s creditors. If the creditors are funding the company then from a directors perspective “the interests of the company are, in reality the interests of existing creditors alone”4. That is, creditor interests effectively become paramount to the interests of all other stakeholders because the risk of failure shifts to a company’s 2 Corporations Act 2001 s 95A 3 Sandell v Porter (1966) 115 CLR, 666, 40 ALJR7 4 Brady v Brady (1987) 3 BCC 535,552 (Nourse LJ) 4
  5. 5. Carl Gunther April 2010 creditors. The law imposes very stringent duties upon directors towards creditors in circumstances of insolvency. 2.2 Director’s duties and insolvency. Directors are subject to a number of duties derived from common law and the statutes. For example, they must exercise their powers and discharge their duties with care and diligence5. Under the Act s588G, directors have a duty to prevent a company from incurring further debt (hereafter defined as trading whilst insolvent) if it becomes or is at significant risk of becoming insolvent. It’s a positive duty under the Act; the company must remain solvent at all times even whilst it’s undertaking informal restructuring. The application of the duty to prevent insolvent trading is set out in the Act 588G (1). A failure to prevent insolvent trading can result in civil penalties, disqualifications and orders to pay compensation.6 Criminal liability may also arise if a director suspected at the time the company incurred the debt that the company was insolvent7. The implications for directors who trade whilst the company is insolvent are therefore significant. 2.3 Civil defences to and relief from proceedings of insolvent trading. There are “mechanisms” under the Act that provide directors with a defence to and relief from the insolvent trading laws. They are discussed in detail in section 3 of this paper however in summary a director can rely upon a number of defences contained in the Act s 588H and in the Act ss1317S, 1318 the courts may excuse a director from civil breaches. 5 Corporations Act 2001 S 180 (1) 6 Corporations Act 2001 Part 9.4B 7 Corporations Act 2001 Section 588 G (3) 5
  6. 6. Carl Gunther April 2010 2.4 Informal v’s formal restructuring in the context of Australian insolvency Having defined “formal” and “informal” restructuring, in the context of the options presented by the Minister, its worth discussing briefly the circumstances giving rise to each type of restructuring and when they are typically deployed. Fig 1 below graphically represents a conceptual view of circumstances giving rise to the two types of restructuring. At KPMG 8 this graph is referred to as the Director Decision Demise curve. In considering Fig 1, the following observations are made: 1. A “successful” informal restructuring will almost always result in a better financial outcome to stakeholders compared to a formal restructuring. This is 8 The author is a Director in KPMG’s restructuring Advisory practice. The views of the author are not necessarily the views of KPMG. 6
  7. 7. Carl Gunther April 2010 because a formal restructure will have a material adverse impact on asset carrying values. 2. “Unsuccessful” informal restructuring activities normally result in insolvency. 3. In concluding their decision as to which route to follow (informal v formal restructuring), what often weighs most on the minds of directors is their personal liability as it applies under the law. 4. The timing of intervention statistically appears to have a major role to play. The earlier a director intervenes on the demise curve, the more likely an informal restructuring will be successful. 5. The longer a director takes to intervene, the less control they have over the outcome and hence the less likely an informal restructuring will be successful. There does not appear to be a way of measuring the success of informal restructuring using publicly available data as most informal restructuring programs are conducted in secret and not reported. One proxy for a measure of successful formal restructurings is available by comparing the number of companies that successfully execute a Deed of Company Arrangement (“DOCA”) under Part 5.3A of the Act , against the number of companies that enter some form of insolvency administration. This conclusion can be drawn since a DOCA is a deal agreed by a company with its creditors as part of the Voluntary Administration procedure. 7
  8. 8. Carl Gunther April 2010 Fig 2: Insolvency Works Business Stress Report Oct 2009. Using data obtained from the Australian Securities Investment Commission, advisory firm; Insolvency Works Pty Limited compiled statistics which form the basis of Fig 2 above. With reference to Fig 29, only 7.3% of companies entering some sort of insolvency administration successfully executed a DOCA in the year to October 2009. There has been a decline from 14.2% in 1999 to the current level. The above statistic is a controversial reference point due to the number and volume of liquidations during the period. However a conclusion that can be made is that the success rate in formally restructuring insolvent companies is low and there is a case for changing the law to improve restructuring outcomes. This argument is reinforced in a joint submission to the Treasury Discussion Paper between the Law Council of Australia, the Insolvency Practitioners Association of Australia and the Australian Chapter of the Turnaround Management Association (“Joint Submission”) discussed at section 2.5 below. 9 Insolvency Works - Business Stress Report October 2009. 8
  9. 9. Carl Gunther April 2010 2.5 Safe harbour The concept of a safe harbour from insolvent trading laws was tabled in the Treasury Discussion Paper on the basis that it (the safe harbour) assisted directors concerned about personal liability when choosing either an informal or formal restructuring. Options 2 and 3 of the Treasury Discussion Paper are types of safe harbour mechanisms. In the Joint Submission there were 5 policy reasons sited as to why a safe harbour should be in place to allow informal restructuring: 1 The existing law, without any safe harbour, can impede or prevent proper attempts at informal workouts. 2 Without any safe harbour, the existing laws have a major effect on honest, capable directors, particularly non-executive directors. 3 the focus of directors of a financially troubled company should primarily be (as it is everywhere else in the world) on the interests of creditors. 4 The existing insolvent trading law limits the options available to deal with financial distress. 5 A safe harbour defence would promote the policy objective of obliging directors to obtain early restructuring advice. These reasons are logical in their approach and lend weight to the concept of a safe harbour for directors. If there are grounds for suspecting a company is insolvent, a director faces an automatic personal liability for debts incurred post the date this is determined. Honest and diligent directors will not breach the law and for this reason they will unfortunately apply a “black and white” application of the law to a very “grey” circumstance. Honest and diligent directors would therefore benefit from a safe harbour approach to insolvent trading laws. 2.6 A case for changing the insolvent trading provisions of the Law Given that informal insolvencies result in a better stakeholder outcomes than formal insolvencies and that the success rate in formally restructuring insolvent companies 9
  10. 10. Carl Gunther April 2010 is low, there would appear to be a strong case for changing the insolvent trading laws in a way that supports informal restructuring. The adoption of a safe harbour approach appears to be consistent with other jurisdictions and there are clear policy reasons for doing so. 3 Discussion of options 3.1 Option 1: the case for Status quo As stated previously, there are “mechanisms” under the Act that provide both a defence to and relief from the insolvent trading laws. A director can rely upon 4 defences contained in the Act s 588H and under the Act ss 1317S, 1318, the courts may excuse a director from civil breaches of the Act. 3.1.1 Defences – Section 588 H of the Act. To defend an action under the Act s 588H, a director must prove: • 588H (2) – they had reasonable grounds to expect solvency. When the debt was incurred the director had reasonable grounds to expect that the company was solvent and would remain solvent if the debt was incurred. This requires more than a mere hope or possibility10. • 588 H (3): That when the debt was incurred the director had reasonable grounds to believe and did believe that a subordinate was competent, reliable and responsible for providing adequate information about the company’s solvency and the directors expected on the basis of this information that the company was solvent and would remain solvent. This section does not negate a director’s duty to keep themselves informed and to form their own judgement about the affairs of the company11. 10 Tourprint pty ltd (1999) 17 ACLC 1,543, [67] 11 Manpac Industries P/L v Ceccattini (2002) 20 ACLC 1,304 10
  11. 11. Carl Gunther April 2010 • 588 H (4) : That at the time the debt was incurred they were absent from management for illness or good reason. A director will not have a good reason merely by not participating in the company’s business12 . • 588 H (5): that all reasonable steps to prevent the debt being incurred were taken. The Act s 588 H (6) makes reference to actions a director can take to prove a defence under s 588 H and they include the director appointing an administrator of the company. Whilst these defences appear to be quite broad, it appears from case law that the courts have interpreted the defences under the Act s588H quite restrictively. 13 Ultimately the burden falls on the director to establish a defence and as Gonski said, it can take years to prove or defend one’s position. For this reason the defences provide little comfort to a director when consider their personal position particularly at the time a decision has to be made to consider a restructuring plan. 3.1.2 Relief from insolvent trading provision. If it is found that a person has contravened a civil provision of Act, the courts may under the Act ss 1317S, 1318, relieve the director wholly or partially from civil liability. The provisions do not provide defences to the insolvent trading laws. All they do is empower the court to relieve an officer from civil consequences of a breach if the director has acted honestly having regard to all the circumstances. The onus of proof is placed on the director to apply to the court. 12 Tourprint pty ltd (1999) 17 ACLC 1,543, [67] 13 Byron v Southern Star Pty Ltd (1997) 15 ACLC 191. 11
  12. 12. Carl Gunther April 2010 There is little case law in respect of the operation of the Act ss 1317S,1318, with respect to insolvent trading. However for the first time, a judge in 2009 provided a director with complete relief from civil penalty following a finding of insolvent trading in the matter of Stake Man Pty Ltd v Carroll [2009] FCA 1415 14 (“Stake Man Case”). It appears then that directors may potentially engage in insolvent trading and yet avoid civil liability. Interestingly the judge in the Stake Man Case rejected all defences put forward by the director under the Act s 588H. He sought to apply the criteria established by Justice Palmer in Hall v Poolman [2007] NSWSC 133015 which until recently was the leading authority on this issue, that in some cases it was commercially sensible to allow a reasonable time for a director to assess whether the company’s difficulty is temporary or fatal. Whilst the outcome in the Stake Man Case was a relief for the director, it was a very expensive outcome as the judge awarded costs against the director. If there is any take away from both cases, its that its rare for a court to apply the Act ss 1317S, 1318, in respect of the insolvent trading provisions. 3.1.3 Summary of the case for Option 1: Status quo Given the risks associated with the insolvent trading provisions, a director is compelled to place a company into administration under the Act s 588 H (6) where they cannot form the requisite view as to an expectation of solvency, even in circumstances where the interests of creditors might be better served by an informal workout. At the time when a director is considering a temporary or permanent illiquidity, it’s difficult to envisage why a director would consider an informal restructure when the defences and relief offered under the Act are weighed down by the heavy burden of proof placed on the directors under the insolvent trading provisions. 14 Stake Man Pty Ltd v Carroll [2009] FCA 1415 15 Hall v Poolman [2007] NSWSC 1330 12
  13. 13. Carl Gunther April 2010 In conclusion, it would appear that the case for Option 1, that is, to keep the status quo of the insolvent trading provisions of the Act would do little to advance the cause for informal restructuring. 3.2 Option 2: the case for a Modified Business Judgement Rule The business judgement rule which operates in relation to the statutory duty of care and diligence under the Act s 180, was introduced to protect the authority of the director in the exercise of their duties and to clarify their liability. Importantly, the Act s180, does not apply to the duty not to trade whilst insolvent imposed under the Act s 588G. For this reason it has been proposed in the Treasury Discussion Paper that the Act s180, be modified in a way to accommodate the insolvent trading laws. 3.2.1 The current business judgement rule Before proceeding with a discussion on the proposed modifications in the Treasury Discussion Paper its worth commenting on drafting of the Act s 180 (2). A director has satisfied their obligations to exercise their powers and discharge their duties with due care and diligence under of the Acts 180 (2) if they: 1 Make a business judgement in good faith for a proper purpose. 2 In respect of a matter in which they do not have a material personal interest. 3 After informing themselves about the subject matter of the judgement to the extent they reasonably believe to be appropriate. 4 Rationally believe that the judgement was in the best interests of the corporation. In the Joint Submission, (referred to in section 2.4 and 2.5 above) , it was noted that the Act s180 (2) (b) (in other words item 2 above) should be deleted or substantially modified. 13
  14. 14. Carl Gunther April 2010 The rationale sited in the Joint Submission was that: “Executive directors will often be employees of the company. Many will be shareholders. They may also be creditors on director loan accounts and a source of that additional capital may be one of the directors or interests associated with that director”. As a result, a director would not be entitled to a defence under the Act s 180 if the above criteria existed. For this reason, the authors of the Joint Submission proposed (the author of this paper also agrees ) that the Act s 180 (2) (b): “ either be deleted, or should be subject to the proviso that none of the above circumstances constitutes a "material personal interest" for the purposes of the application of the rule to this defence to Insolvent trading” 3.2.2 Proposed modifications to the Business Judgement Rule At paragraph 5.3.6 of the Treasury Discussion Paper are 4 proposed modifications to the business judgement rule that would apply in respect of the insolvent trading provisions of the Act. They would operate so that directors would be relieved of the duty not to trade whilst insolvent if the following elements are satisfied: 1 the financial accounts and records of the company presented a true and fair picture of the company's financial circumstances; 2 the director was informed by restructuring advice from an appropriately experienced and qualified professional with access to those accounts and records, as to the feasibility of and means (“a plan”) for ensuring that the company remained solvent and that it was returned to a state of solvency within a reasonable period of time; 3 it was the director's business judgment that the interests of the company's body of creditors as a whole, as well as members, were best served by pursuing (informal?) restructuring; and 4 the restructuring was diligently pursued by the director. 14
  15. 15. Carl Gunther April 2010 3.2.2.1 Modified business judgment rule- a true and fair view? The objective that the accounts of the company present a true and fair view is to ensure the financial information is meaningful and the basis of financial data for any decision is accurate. However for the following reasons, a true and fair view of the historical records of the company has a number of limitations: 1 Are the company’s records and accounts true and fair. The Treasury Discussion Paper rightly refers to the situation where a “person seeking protection may be required to engage in disputes as to the accuracy of financial records”. 2 Accounts that represent a true and fair view are historical in nature. The primary test of insolvency is determined through the use of forward-looking cash flows- that is, the ability of a company to pay its debts as and when they fall due. A true and fair view would not present forward-looking cash flows. 3 Just because the accounts of a company are not True and Fair should not preclude a company and the directors from attempting an informal restructuring. In the Joint Submission at paragraph 5.10 (b), it was stated that the true and fair view modification should be changed to reference “any information necessary for the provision of restructuring advice”16. Since many factors are at play in forming an opinion as to the success of otherwise of a restructuring plan, its important that the modified rule remain sufficiently wide to accommodate the provision of restructuring advice. 3.2.2.2 Modified business judgment rule- an appropriately experienced and qualified professional? The authors of the Treasury Discussion Paper sought to enforce the concept that Directors ought to get independent advice. Case law supports the requirement to seek advice however the question arises as to what actions if any the director should take in adopting the advice given. For this modification to be meaningful, a director should be required to follow the advice (or provide a good reason why they didn’t) rather than merely seek it. This needs to be balanced against the need for directors to exercise their own judgement not withstanding the advice given. It would be a 16 Paragraph 5.10 (b) of the Joint Submission 15
  16. 16. Carl Gunther April 2010 bold director to ignore, or worse, go against the advice of the appropriately qualified professional under the modified business judgement rule. In their submission to the Treasury, the contributors to the Joint Submission17 made reference to and suggested that the modified rule: “must accommodate the appointment by the company of appropriate personnel with specialist skills, such as a chief restructuring officer (CRO)”. A controversial move, since the CRO by default will become an officer carrying the responsibilities of a shadow director! A move the author of this paper does not support. 3.2.2.3 Modified business judgement rule- interests of the company's body of creditors as a whole, as well as members? This rule appears to make sense however its important that the interpretation of the rule does not set the interests of creditors against members and vice versa. 3.2.2.4 Modified business judgement rule- the restructuring was diligently pursued by the director? This rule appears to make sense however there is no time limit and it will remain a function of the restructuring plan as to what role the director will take. The director should ensure the company diligently pursues the restructuring plan. 3.2.3 Summary of the case for a Modified Business Judgement Rule ? A case exists for the introduction of a modified business judgement rule as proposed (and varied) under Option 2 of the Treasury Discussions Paper to create a “safe harbour” in which to activate informal restructuring. Industry practitioners see such a step as positive provided certain modifications are made to the rules. 17 Treasury Discussion Paper between the Law Council of Australia, the Insolvency Practitioners Association of Australia and the Australian Chapter of the Turnaround Management Association (“Joint Submission”) 16
  17. 17. Carl Gunther April 2010 3.3 Option 3 – the case for a Moratorium from the insolvent trading laws? This option would require a company to inform the market, including existing creditors and potential new creditors that the company was insolvent and intended to pursue an informal restructuring. The concept is appropriate, particularly in the context of transparency with current and future creditors, however for the following reasons, this option 3 is likely to fail in the context of an informal restructuring. Publicly declaring insolvency: 1 is likely to trigger any number of the termination rights in the contracts the company has with suppliers and customers. This would have the impact of materially adversely impacting asset carrying values and the recoverability of such values. 2 would impact a creditor that receives post announcement payments since the receipt of such funds would expose them to claims by a liquidator that they received an unfair preference. 3 would likely bring on the process of a formal restructuring rather than an informal restructuring as substantial cash flow burdens would be brought to bear on the company. 4 is likely to force all creditors to seek enforcement of their rights under contract. Human behaviour being what it is will result in “every man for himself” rather than “every man for the company”. 4 Other observations about the Treasury Discussion Paper. Whilst perhaps not the intention of authors of the Treasury Discussion Paper, there was no attempt to resolve some of the difficulties around assessing insolvency. For example, there is no attempt to simplify the meaning of insolvency or clarify issues 17
  18. 18. Carl Gunther April 2010 such as how far into the future a director must look in assessing a company's present solvency. There is a reluctance to seek to adopt the laws as they apply in other similar common law jurisdictions. An inventing the wheel mentality has been adopted. 18
  19. 19. Carl Gunther April 2010 5 Bibliography Texts • Murray, Michael, Keay’s Insolvency: Personal and Corporate Law and Practice 6th edition 2009 Legislation • Corporations Act 2001 Publications • Insolvency Works Pty Limited- Business Stress Report October 2009. • Insolvent Trading: a Safe harbour for reorganisation attempts outside of external administration January 2010, The Treasury (Treasury Discussion Paper) • Law Council of Australia, the Insolvency Practitioners Association of Australia and the Australian Chapter of the Turnaround Management Association (“Joint Submission”) submission to Treasury Discussion Paper, 2 March 2010 • ASIC Consultation Paper 124: Duty to prevent insolvent trading: guide for Directors. November 2009. • Queensland University of Technology – Reading notes Semester 1 Insolvency Law and Professional Practice. • KPMG Restructuring Guidance notes: January 2010 Directors Decision Demise Curve. Cases • Sandell v Porter (1966) 115 CLR, 666, 40 ALJR7 • Tourprint pty ltd (1999) 17 ACLC 1,543, [67] • Manpac Industries P/L v Ceccattini (2002) 20 ACLC 1,304 • Byron v Southern Star Pty Ltd (1997) 15 ACLC 191. • Stake Man Pty Ltd v Carroll [2009] FCA 1415 • Hall v Poolman [2007] NSWSC 1330 • Brady v Brady (1987) 3 BCC 535,552 (Nourse LJ) Other • Gonski, David Australian Securities Investments Commission Annual Policy Summit Melbourne February 18 2008 19

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