On the Case: Issue 25

A safe harbour for Directors - it is an illusion?

In this edition of On the Case, Adjunct Professor Philip Stern, who has taught Insolvency Law at the School of Law, Sydney discusses the safe harbour provisions in the Corporations Act.

The Issue

Section 588G of the Corporations Act 2001(“the Act”) imposes a duty on company directors to prevent a company from trading whilst insolvent.¹ A director² can be personally liable for debts incurred by a company if, at the time the debt is incurred, there are reasonable grounds to suspect that the company is insolvent. Breaching this provision can give rise to both civil and criminal penalties. The focus of the section is on the timing of when debts are incurred, rather than on the conduct of the director in incurring the debt.³ The existing statutory defences to an action are very limited.⁴

The Commonwealth Government identified a number of potentially undesirable outcomes from the existing legislation.⁵ They are:

• As the threshold is not actual insolvency, but ‘reasonable grounds for suspecting‘ insolvency, directors may cease trading prior to commencement of insolvency proceedings, limiting the ability of the company to trade through financial difficulty
• Directors may have disproportionate concern as to their own personal exposure and thus move to formal insolvency prematurely or focus on their own liability rather than potential ways to remedy the situation
• Investors and skilled business persons are deterred from taking up directorships especially in higher-risk start-up companies
• Directors may not focus on their general director duties and make early appointments of administrators thus potentially destroying enterprise value notwithstanding clear opportunities to adjust a company’s business for the benefit of the company, its shareholders, creditors and employees
• Even where a company may be solvent or could be turned around, an administrator appointment may result in the company being liquidated because of loss of confidence by suppliers, financiers, employees and the general public, and
• Unnecessary liquidations of companies that could have been restructured and continue to operate.

None of these outcomes are considered to be in the interests of the various stakeholders, nor the economy as a whole.

The New Law⁶

Section 588GA now exempts directors from civil liability under s 588G provided that:

• at a time after the director starts to suspect the company may be, or is, insolvent, the director starts developing a course of action that is reasonably likely to lead to a better outcome for the company⁷
• the debt is incurred, directly or indirectly, in connection with the course of action provided it is implemented within a reasonable time; or the director ceases to take the course of action or it ceases to be reasonably likely to lead to a better outcome for the company; or the company enters into a formal insolvency administration.⁸

The director bears the evidential onus of proving that the course of action is ‘reasonably’ likely to lead to a better outcome.”⁹ Factors relevant include whether the director is:

• properly informing himself/herself of the company’s financial position
• taking appropriate steps to prevent officer/employee misconduct
• taking appropriate steps to ensure the company is keeping appropriate financial records
• obtaining advice from an appropriate qualified entity who was given sufficient information to give appropriate advice, or
• is developing or implementing a plan for restructuring the company to improve its financial position.¹⁰

There are also vitiating factors which make the safe harbour provided by s 588GA unavailable. They are failures to:

• pay employee entitlements when due, or
• meet taxation reporting obligations,¹¹ or
• substantially comply with reporting obligations and delivery /inspection of /access to documentation to insolvency practitioners if subsequently appointed.¹²

Intention of the Legislation

In his Second Reading Speech¹³ the Minister for Small Business stated that these

“the safe harbour ...measures [were designed to] encourage Australians to take a risk, leave behind the fear of failure and be more innovative and ambitious”.

The question is whether the amendments achieve this goal?

What is not taken into account?

The new safe harbour provisions clearly afford company directors a higher measure of protection. But, (in no order of priority):

• there is no carve-out from personal guarantee liabilities for debts incurred during the safe harbour period.¹⁴ This may be a serious issue for the common director guarantees given to suppliers, financiers and landlords.
• There is no carve-out for breaches of other director duties during the safe harbour period. Those duties include a general duty of care and diligence¹⁵ and the duty to act in good faith in the ‘best interests of the corporation’ and for a proper purpose.¹⁶ There is authority that directors of an insolvent company owe a duty to that company to consider the interests of its creditors (but do not a duty directly to the creditors).¹⁷ Thus a company liquidator may still be able to sue directors for debts incurred during safe harbour particularly if the debt position deteriorated during that time.
• The Australian Stock Exchange (ASX) Listing Rule 3.1 requires an entity to immediately tell the ASX once it becomes aware of information that a reasonable person would expect to have a material effect on the price or value of the entity’s securities.¹⁸ Compliance with Rule 3.1“is critical to the integrity and efficiency of the ASX market”.¹⁹ The ASX considers that entities in financial difficulties are subject to the same Rule 3.1 disclosure standards as other entities.²⁰ However, the fact that a company is in safe harbour is not something the ASX considers automatically requires disclosure.²¹ When there are genuine financial difficulties, the proper course is to approach the ASX for a voluntary suspension. In those circumstances, if the ASX is satisfied that continued securities trading could materially prejudice critical transactions or continued financial viability, then the suspension may be approved.²² Directors of ASX listed entities thus face a number of conundrums – disclosure that a company is in safe harbour may send its shares into free-fall which would defeat the point of safe harbour; to have the company placed into voluntary suspension may have investors reading between the lines and similarly send its worth plummeting when re-listed; yet non-disclosure, even if based on the confidentiality carve-out in Rule 3.1A, may still lead to shareholder class actions if a safe harbour course of action is unsuccessful or is not implemented.
• A director seeking director and officer insurance must act with the utmost good faith,²³ and disclose to the insurer, every known matter known relevant to the decision of the insurer to accept the risk before the relevant contract of insurance is entered into.²⁴ Disclosure of safe harbour reasons and arrangements are likely required to comply with those duties and could result in the unavailability of such insurance or with significantly higher premiums or excess.
• A breach of s 588G can incur a criminal sentence of up to 5 years imprisonment.²⁵ The Crimes Acts of the States make it a crime to conceal a ‘serious indictable offence’ committed by another person, unless the failure to report is because of a ‘reasonable excuse’. A ‘serious indictable offence’ generally applies to an offence punishable by a term of 3 years or more imprisonment.²⁶ Thus a non-lawyer²⁷ but ‘appropriately qualified’ adviser, ought to report to a relevant authority (likely ASIC), a director who consults him/her if the director has been or will be trading insolvently, in order to comply with Crimes Act obligations.²⁸ That is a serious disincentive to a director consulting a professional adviser for safe harbour.
• Most insolvency practitioners, being ‘appropriately qualified persons’ for s 588GA purposes, will also be members of professional accountancy bodies in Australia. If so they must comply with the Accounting Professional & Ethical Standards Board Code of Ethics for Professional Accountants (“APES 110”).²⁹ If they were to find insolvent trading they will need to consider whether to report that to the company’s auditor³⁰ and whether to disclose that to an appropriate authority.³¹ Whether the disclosure is contrary to law or regulation, and/or whether the engagement is to investigate potential non-compliance to enable the entity to take appropriate action³² are relevant factors in such consideration. If the accountant believes that intended conduct would  constitute an imminent breach of  a law that would cause substantial harm to investors, creditors, employees, or the general public then he/she may disclose the matter to an appropriate authority (after discussion with management or those in governance of the company).³³ It may be that trade-ons for a company in safe harbour may be of overall benefit to the company (because it may reduce the likelihood of a winding up). But if the safe harbour arrangements may be detrimental to some stakeholders (for example, some creditors may be worse off), reporting may be required.
• The Australian Taxation Office retains all its rights notwithstanding that a company may be in safe harbour. Those rights include issuing Director Penalty Notices (DPNs) to directors whose companies fail to pay PAYG and superannuation obligations when due³⁴ making the director personally liable for the unpaid tax. DPNs might be avoided if the company was placed into a formal insolvency regime. Further, if the ATO was aware of the safe harbour entry and received PAYG or superannuation guarantee charges payments during that time, it would likely need to disgorge the payments to the company’s liquidator as an unfair preferential payment if a liquidator was appointed within 6 months of the payment to the ATO.³⁵ If the ATO were to disgorge such a payment, it can rely on s 588FGA of the Act to recover those moneys from the company’s directors who could not rely upon the fact that the company was in safe harbour.³⁶ If the company had immediately gone into an insolvency administration, the directors would not have faced the indemnity obligations arising from s 588FGA for payments made during safe harbour.³⁷
• Directors who consult insolvency practitioners for safe harbour advice may find that the practitioner is barred from accepting a subsequent formal insolvency appointment, if the advice is extensive or of long duration. The practitioner is obliged to disclose his/her relationship if it occurred within 24 months of the appointment ³⁸ and may have a conflict of interest or duty barring him/her from taking the fresh appointment.³⁹ Thus a company runs the risk of incurring substantial fees to a practitioner, only to have to ‘re-educate ‘a fresh firm at more expense if a new insolvency appointment is subsequently determined to be appropriate.
• If safe harbour is not confidential then suppliers may cease to supply or change terms to overcome risk including preferential payments claims. Changed terms might include the requirement of cash on delivery, director guarantees, or increased charges. Financiers and landlords might also regard entry into safe harbour as ‘a material adverse change’ within their contractual documents terms and accelerate indebtedness or terminate their arrangements, thereby precipitating the corporation’s demise.
• If safe harbour is not disclosed, then creditors who consider they have been damaged by the process may assert that were misled or deceived by the directors in breach of the Australian Consumer Law⁴⁰ since the safe harbour arrangement was information which the directors knew or ought to have known was material to the ongoing trading relationship with the supplier.
• There may also be difficulties in compliance with the terms of s 588GA itself. They include :
  • The obligation to pay employee entitlements when due (s 588GA(4)(a)(i)). The question of who is an ‘employee’ is vexed. Because a person performing duties is identified as a ‘contractor’ in a contractual document, does not mean the person is not an employee within the meaning of other branches of the law. ⁴¹ A wrong determination may prevent s 588GA from operating. Similarly, classifications in modern awards can be difficult to determine as employee duties may traverse different classifications.⁴² If a wrong award classification is made and results in underpayments, then the safe harbour will be vitiated.
  • What is a ‘better outcome for the company’ may be the subject of dispute. Is the company merely the entity itself, or is it the shareholders, its creditors, employees or the public?⁴³ Until case law answers this question, directors may be unsure of compliance with s 588GA(1)(a)
  • The obligation to develop courses of action ‘reasonably likely’ to lead to a better corporate outcome,⁴⁴ which may improve its financial position⁴⁵ is on-going. Once a plan ceases to meet the criteria for better outcome or improvement, it needs to be abandoned or modified. A failure to abandon or modify a safe harbour plan when circumstances dictate that need, will mean that the directors are no longer protected by the safe harbour.
  • Advice needs to be from an ‘appropriately qualified entity’.⁴⁶ That term includes an experienced insolvency practitioner. However the Act is not limited to them and other advice may be more appropriate.⁴⁷ Multiple advisors with different specialities may be required in the case of an exporting mining company – for example, an insolvency practitioner with a mining engineer and economist. While there is room for imagination and innovation in the choice of appointees, directors also need to ensure that the appointees have either private wealth or adequate professional indemnity insurance should their advice prove unsuccessful.
  • The onus on establishing a reasonable likelihood of a better outcome from a safe harbour plan lies with the director.⁴⁸ Thus, the reasons for any plan should be documented along with all discussions of alternatives and the reasons for the reasonableness of belief in the beneficial outcome. A failure to adequately document and record the process may result in an inability of the director to satisfy his/her evidentiary onus, particularly as a court case may not be heard until many months after the relevant events.

Summary/conclusion

The safe harbour provisions in the Corporations Act provide greater protection to company directors making trading decisions in the context of corporate financial difficulty. However, there are practical and interpretive traps hidden within the new safe harbour legislation and no reported cases that resolve the issues of concern. Until there is legislative or judicial clarification, directors should tread cautiously even though the benefits to directors, their companies and society can be significant.

This article is an edited version of an advice for clients prepared by Phil Stern in his role as a consultant to Woodgate and Co, Solicitors in Sydney. Phil is also an Adjunct Professor at the Sydney School of Law of The University of Notre Dame Australia.

¹ Section 588V imposes an equivalent duty on a holding company for debts incurred by its subsidiary when insolvent.
² A ‘director ‘is not simply a person formally appointed to act in that position. It also can include a person who acts in the position of a director or a person to whose instructions or wishes directors are accustomed to follow -see s 9.
³ The director’s conduct can be taken into account however in determining whether there should be relief from liability, in whole or part - see s 1317S and 1318.
⁴ Section 588H(s 588X for holding companies).Those defences are that the director had reasonable grounds to expect, and did expect, that the company was solvent when the debt was incurred and would so remain solvent; that the director relied on competent and reliable advice that the company was solvent; or that the director, through illness or other good reason, did not take part in management of the company when the debt was incurred.
⁵ See the Explanatory Memorandum to, the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Bill 2017, [1.7] to [1.10].
⁶ The amendments took effect from 19 September 2017.
⁷ Section 588GA(1)(a). By s 588GA(7), a ‘better outcome ‘ is defined to mean an outcome better for the company than the immediate appointment of an administrator or liquidator to the company. ⁸ Section 588GA(1)(b).
⁹ Section 588GA(3).
¹⁰ Section 588GA(2).
¹¹ Section 588GA(4)(a). By s 588GA(4)b), the failure must be less than substantial compliance, or is one of two or more failures by the company to do those matters during the 12 month period ending when the debt was incurred.
¹² Sections 588GA(5) and 588GB. By s 588GA(6) the Court can excuse the failures under s 588GA(5) and (6) if exceptional circumstances exist.
¹³ Mr McCormack, 1 June 2017
¹⁴ Unlike say, s 440J ,which legislates  a moratorium on guarantee enforcement during a voluntary administration.
¹⁵ Section 180, for which there is a business judgment defence. ¹⁶ Section 181.
¹⁷ See, for example Walker v Wimborne (1976) 137 CLR  1, [6-7] referred to in Speirs v The Queen(2000) 201 CLR 603. The rationale for this duty is set out in Re New World Alliance Pty Ltd; Sycotex Australia Pty Ltd v Basseler [1994] FCA 1117; (1994) 51 FCR 425, 445 as being because the creditors of an insolvent, or near insolvent, company are to be seen as having a direct interest in the company which cannot be overridden by shareholders. See also Termite Resources N.L.(in liq) v Meadows[2019] FCA 354, [197-209] and the cases referred to therein.
¹⁸ There are limited carve-outs to Rule 3.1 in Rule 3.1A. They include that the information is confidential and that the ASX has not formed the view that the information has ceased to be confidential.
¹⁹ ASX Guidance Note 8, [1].
²⁰ ASX Guidance Note 8, [5.10].
²¹ Ibid. It also considers that once a definite plan has been determined, or the fact the company is in safe harbour ceases to be confidential, disclosure is required.
²² Ibid.
²³ Section 13, Insurance Contracts Act1984 (Cth)
²⁴ Section 21, Insurance Contracts Act 1984 (Cth). Continuing disclosure obligations are also invariably mandatory contractual terms in professional indemnity and directors and offices insurance policies. That is, disclosure of safe harbour to an insurer may be required immediately it occurs.
²⁵ Schedule 3 to the Corporations Act, item 138 and s 1311 as applicable to s 588G(3). The Court can also charge up to 2000 penalty units in addition or alternatively. A penalty unit is now $210 (Crimes Act (Cth) s 4AA). Breaches of s 588G may also incur civil penalties under ss 1317E and 1317G of up to $200,000.00 for an individual (effectively a fine).
²⁶ See for example, s 316 Crimes Act 1900 (NSW). A breach of this section may give rise to a sentence of up to 2 years.
²⁷ Lawyers who are consulted in safe harbour cases are likely to have the communications subject to common law legal professional privilege. Also they are excluded from reporting obligations in NSW by r 4 of the Crimes Regulation 2015 (NSW). There is no exclusion for insolvency practitioners.
²⁸ It is recognised that reporting rarely, if ever, occurs. However, it is unlikely the ‘reasonable excuse ‘exclusion to s 316 would apply to safe harbour as s 588GA is directed towards exclusion from civil liabilities under s 588G(2), not criminal prosecution.
²⁹ APES 110 was amended from 1 January 2018 to deal with circumstances of non-compliance with laws and regulations (NOCLAR) which a member becomes aware of.
³⁰ APES 110 cl 225.44-225.48. The auditor may then qualify the accountants, potentially jeopardising the company’s ongoing viability, particularly if the accounts are publically available.
³¹ APES 110 cl 225.51
³² APES 110 cl 225.52. The accountant should ensure that his/her retainer agreement contains confidentiality terms so as to argue that disclosure is contrary to the law of contract.
³³ APES 225.54
³⁴ And soon also GST
³⁵ See s 91 re ‘relation-back date’
³⁶ See s 588FGB, which applies the same defence provisions as s 588H.
³⁷ But of course if the safe harbour stratagem succeeded the company would not go into an insolvency administration.
³⁸ Sections 60, 449CA, and 506A. See also s 448C and 532 which bar the practitioner from taking the appointment, without leave of the Court, if owed more than $5000.00 by the company.
³⁹ But see, in the context of complex corporate groups or companies Re Korda; in the matter of Ten Network Holdings Ltd (Administrators appointed)(Receivers and Managers appointed)[2017] FCA 914; In the matter of RCR Tomlinson (administrators appointed ) [2018] NSWSC 1859, [5] (without analysis). The consulting practitioner is also not immune from actions for negligence, inter alia, if the company’s position deteriorated during safe harbour, for example, which justifies the appointment of an alternative firm for a formal appointment.
⁴⁰ Section 18 to Schedule 2 Competition and Consumer Act 2010 (Cth).
⁴¹ See the seminal case of Hollis v Vabu Pty Ltd (2001)207 CLR 21 and most recently Quian v Commissioner of Taxation [2019] AATA14.
⁴² See, for example, Fair Work Ombudsman v Viplus Pty Ltd [2017] FCCA 1669.
⁴³ An example of the dilemma would be the facts in Longley v Chief Executive, Dept of Environment and Heritage Protection [2018]QCA 32 where it may have been in the company, its shareholders and creditors interests to abandon a mining site requiring substantial environmental remediation at significant cost, but this may not have been in the public interest.
⁴⁴ Section 588GA(1)(a).
⁴⁵ Section 588GA(2)(e).
⁴⁶ Section 588GA(2)(d).
⁴⁷ For example, what of an in-house counsel?
⁴⁸ Section 588GA(7). A ’better outcome ‘means better for the company than an immediate insolvency practitioner appointment.