Government considers sweeping reforms to corporate insolvency laws

On 19 January 2010, in response to perceptions of inflexibility in Australia’s corporate insolvency regime, Chris Bowen, the Minister for Financial Services, Superannuation and Corporate Law, announced a major review of Australia’s insolvency laws.

At the forefront of the Government’s review is a possible shake-up to laws which prevent directors from pursuing informal corporate restructuring on insolvency.

In recent years much attention has been focused on the utility of the US Chapter 11 bankruptcy laws which, broadly, allow companies to continue to trade during the restructuring process.

In Australia, a company must maintain solvency in order to attempt an informal work-out.

On announcing the review, Chris Bowen underlined the importance of informal corporate reconstructions:

“Informal work-outs play an important role in business rescue and therefore the protection of the shareholders, creditors and employees of distressed businesses. The use of formal insolvency reorganisation procedures is not always appropriate.”

Proponents of the Chapter 11-style system argue that allowing insolvent companies to trade during the restructuring process is often the best way of maximising shareholder and creditor returns, a view which appears to have some support at government level.

Directors’ duty to prevent insolvent trading

Section 588G of the Corporations Act 2001 (Cth) provides that a company director may be liable to civil liability and/or criminal penalty if:

• they are a director of a company at the time when the company incurs a debt;
• the company is insolvent at that time, or becomes insolvent by incurring that debt; and
• at that time, there are reasonable grounds for suspecting that the company is insolvent, or would become insolvent.

Civil penalties include a fine of up to $200,000, disqualification from managing companies and/or an order requiring the payment of compensation.

Criminal liability may also arise if a director’s failure to prevent the company incurring the debt was dishonest. In such circumstances (in addition to any civil penalties), a director can be liable to a maximum penalty of $220,000 or five years imprisonment, or both.

Moving for reform

In its discussion paper, Treasury acknowledges that the personal liability regime may be a disincentive for directors to engage in restructuring processes outside of external administration.

The intention of the potential reforms is to reduce the incidence of companies being placed into external administration prematurely or in circumstances where a better outcome could have been achieved through an informal work-out.

Treasury suggests two options:

• a modified business judgement rule; or
• a mechanism for invoking a moratorium from the insolvent trading prohibition while work-outs are attempted.

Modified business judgement rule

Under this proposal, a modified business judgement rule would operate so that directors would not be considered to have breached their duty not to trade whilst insolvent if:

• the financial accounts and records of the company presented a true and fair picture of its financial circumstances;
• the director was appropriately informed by restructuring advice based on those accounts and records;
• it was the director’s business judgement that the interests of both the creditors and members were best served by pursuing restructuring without appointing external administration; and
• the restructuring was diligently pursued by the director.

The Minister has expressed a preference for this option.

Expressed moratorium rule

Under this option, the company would inform the market, including existing creditors and potential new creditors that the company was insolvent and intended to pursue a work-out outside of external administration.

A moratorium would then apply, during which “honest insolvent trading” would be permitted. Creditors would be empowered to bring the moratorium to an end by either passing a resolution or by obtaining a court order. Restrictions would be placed on the duration of the moratorium.

A new safe harbour

The changes proposed by the discussion paper will have far reaching implications for company directors.

Moves to liberalise the insolvency regime will inevitably be welcomed by directors but there is likely to be some opposition to the reforms, particularly from shareholder and creditor representative groups concerned about protecting rights of action against directors and from banks anxious about the effect of the expressed moratorium mechanism on their rights as secured creditors.

Ultimately however, debate is likely to centre on the legitimacy of allowing “honest insolvent trading” and, to the extent that it is acceptable, on how much insolvent trading is too much.

Treasury is inviting submissions on the insolvent trading discussion paper by 2 March 2010.