How insolvency safe harbour can offer protection

As corporate financial distress is on the rise, it is important for directors to refresh their understanding of insolvency safe harbour provisions, write Michael Sloan and Daniel Dai from Ashurst. 

The first signature reform of the Coalition government’s innovation agenda in 2016 was not a climate change, NBN, or media reform. It was a US-style Chapter 11 insolvent trading carve- out called “Safe Harbour”, established under the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017. Introduced in benign economic times, safe harbour lay dormant during the pandemic.

The following years were relatively quiet years for insolvency. Come March 2020, a tsunami of insolvencies was predicted, but law reform and a moratorium reduced insolvency levels to historic lows. Corporate insolvencies dropped 42 per cent by June 2020 and that trend continued throughout the pandemic. Now, in an environment of inflation, rising interest rates and supply chain blockages, insolvencies are approaching and passing pre-pandemic levels. Because safe harbour has not yet been tested in court or seen regularly in the market, it is truly a sleeper. The 2022 federal government review by an independent expert panel (chair Genevieve Sexton, Leanne Chesser and Stephen Parbery FAICD) found that it has been an effective insolvency reform. Most of its recommendations are focused on simplifying and clarifying the safe harbour provisions rather than amending them in substance.

If the economy does transition from dreamlike state to nightmare, then understanding safe harbour is critical for boards and directors.

What is safe harbour?

Safe harbour is a carve-out from insolvent trading liability for directors. It enables directors to pursue restructuring or a turnaround of a distressed company without fear of personal liability, providing certain conditions are met. Safe harbour applies to a director if:

• The director begins to suspect the company is, or may become insolvent.
• The director then starts developing one or more courses of action reasonably likely to lead to a better outcome for the company (that is, a restructuring plan) than an immediate voluntary administration or liquidation.
• The company incurs a debt in connection with the course(s) of action.
  

Importantly, the director cannot continue to run the company in the same manner as pre- insolvency. Hope is not a course of action. A fresh course of action must be developed in response to the suspicion that the company is, or will imminently be, insolvent.

Application thresholds

The company must meet three threshold requirements to qualify for safe harbour:

• It has paid the entitlements of its employees by the time they fall due, including superannuation.
• It has lodged the necessary tax reporting documents with the ATO or relevant state revenue office.
• It has complied with its obligations to maintain sufficient financial books and records.

Failing to pay employee entitlements or lodge tax documents is not an obstacle to safe harbour if there has still been “substantial compliance” with the obligation and it is the first such failure in the 12 months prior to the debt being incurred. Best practice is to make sure there is no argument about each of the thresholds.

Entering safe harbour

A formal resolution by the board is not required. Rather, the board must be satisfied that any restructuring plan adopted is reasonably likely to produce the requisite “better outcome” for the company. Good practice suggests documenting the steps taken to satisfy the safe harbour carve-out, which may be done through meeting minutes. Directors should keep a thorough record of all documents pertaining to safe harbour.

Legal advice

Legal advice relating to safe harbour is privileged. But when the advice is issued to the company, it will be available to subsequently appointed insolvency practitioners. Contrary to the usual wisdom, it is in the directors’ interest for the advice to be prepared in such a way that it can be provided and relied upon in defence of any claims for insolvent trading. Disclosure of advice to the company will usually aid in establishing the requisite elements of safe harbour. Advisers should write their advice expecting it to be seen. Nonetheless, the cloak of privilege can be beneficial where potential litigation with counterparties may arise independently.

Disclosure

Entry into safe harbour does not, in and of itself, require disclosure. However, the material facts underlying the decision to rely upon safe harbour raise two disclosure issues.

First, continuous reporting obligations imposed on public companies still apply. The facts raising the directors’ suspicion of insolvency may be disclosable, so care should be taken.

Second, the material facts may need to be disclosed to counterparties in any debt or equity raising by the company.

Safe harbour adviser

For medium to large companies, a recognised insolvency specialist from a leading accounting firm should be appointed as a safe harbour adviser — for the largest companies, more than one adviser is necessary. In addition to a recognised insolvency specialist, legal advice should be sought from a restructuring and insolvency partner at a leading law firm. Both board and company should obtain independent legal advice relating to safe harbour.

For small companies, it will generally make sense to engage a leading insolvency practitioner or lawyer. But it may be that a restructuring expert familiar with the business that the company is in will be best placed to take on the role. For example, a small graphic design company may want to engage a seasoned graphic designer as their safe harbour adviser.

How long does it last?

There is no legal time limit on safe harbour, but rule of thumb is that a company’s reliance on safe harbour will last no less than six months, but generally no longer than 18 months.

What debts can be incurred?

During safe harbour, questions will arise concerning exactly what liabilities can be incurred. For major expenditure, the commercial rationale and its link to the restructuring plan must be interrogated. Care should be taken to avoid undue risk. Equally, facilitating a turnaround of the company’s situation entails risk. There is no clear answer. Each significant debt to be incurred must be considered on its merits. Considering, reviewing and documenting the rationale is key.

How regular should meetings be?

Once the board pursues a restructuring plan, it should meet more regularly to oversee the plan’s implementation and to ensure the requisite “better outcome” remains reasonably likely. At a minimum, the board should meet monthly. For a heightened level of concern, fortnightly, and if the company is in crisis, weekly.

What if the problem is terminal?

Safe harbour is only available while the course of action is reasonably likely to lead to a better outcome. If the company’s difficulties become terminal, directors will no longer be protected. Directors should, at this point, declare insolvency.

Can the company raise new money while in a safe harbour?

The company can still raise fresh capital. However, directors should be mindful of disclosure obligations relating to the facts underlying the need for safe harbour.

What is the best advice for directors?

When there is financial distress, calm heads are needed. Most lawyers no longer quote case law to clients. But one quote directors always ask to be requoted comes from the insolvent trading case Hall v Poolman (2009) 75 NSWLR 99 — “a reasonable time must be allowed to a director to assess whether the company’s difficulty is temporary and remediable, or endemic and fatal”. It provides judicial imprimatur for taking time to deal with financial distress unless things are completely dire. Panicked decisions should not be made, but if the position is terminal, there’s no point delaying the inevitable.

Michael Sloan is a partner and Daniel Dai a lawyer with Ashurst’s restructuring, insolvency and special situations practice.

Insolvency state of play

Insolvency numbers dropped to a decade low as expansionary monetary policy, government stimulus, a soft Australian Taxation Office (ATO) enforcement position and debt recovery-limiting legislation all worked to preserve jobs and minimise recessionary risk as the pandemic played out. However, these moves provided extended life to “zombie” companies that would ordinarily have been wound up. Various industry sectors continue to feel the pressure.

Construction and property

Builders are working to complete developments on fixed-price contracts entered into up to three years ago, while now facing higher labour and input costs, and increasing financing pressure. The ATO is requiring delayed tax debt to be paid. While some builders have negotiated improved payment terms enabling cost escalation relief, many have not. The increase in the number of insolvency appointments in the past two years has risen to historic levels.

Accommodation and food services

The impact of rising interest rates and rental hikes over the past 18 months are expected to persist into 2024, placing further pressure on household discretionary spending. As this drops, consumer behaviours will change, creating challenges for the hospitality industry. Potential responsible gambling legislation under discussion might also impact earnings and valuations in the club and pub sector.

Retail trade

Compared to a year ago, we can confirm (with our calculations based on Australian Bureau of Statistics figures) a fall in discretionary spending over the year. Driving this downturn was a 4.4 per cent less spend on furnishings and household equipment over the year, and a 1.5 per cent less spend on clothing and footwear as households respond to rising cost-of-living pressures. With discretionary spending expected to continue to tighten, input costs and overhead management will prove critical for many retail operations.

Forecast

As 40 per cent of fixed-rate home loans outstanding in January 2022 mature by December 2023 (with another 20 per cent maturing by December 2024) with further rental pressure, sectors reliant on consumer spending might experience reduced demand. Market uncertainty is likely to drive businesses to postpone or reconsider expansion and investment. This lack of investment will compound any economic slowdown. Increased borrowing costs will heighten the challenges being faced for many companies in the construction, hospitality, retail and other industries.

Andrew McCabe is a partner and Isha Yadav is an analyst with Wexted Advisors, restructuring and safe harbour specialists.

Safe harbour success stories

Jason Preston, chair of McGrathNicol, says using safe harbour has resulted in a better outcome for several companies the restructuring advisory has worked with recently.

Over the course of 18 months, a large renewable energy operation was able to renegotiate with financiers and contractors, and recapitalise in a way that stabilised its projects and avoided insolvency.

A construction contracting business that incurred losses on projects and was in breach of banking covenants, used safe harbour to prepare a turnaround plan and renegotiate with contract counterparties.

“The business used the safe harbour period to restructure the business to the point where it was able to raise new capital,” says Preston. “Absent the safe harbour provisions, a number of directors were unlikely to support continuing to trade and would likely have appointed voluntary administrators. Safe harbour afforded them the breathing space and governance framework required to achieve a better outcome for the company without exposing themselves unnecessarily to personal liability if the plan was ultimately unsuccessful.”

This article first appeared under the headline 'Safe Harbour Sleeper’ in the September 2023 issue of Company Director magazine.