Innovation in Australia: how safe is the safe harbour?

As the limited liability company was created to encourage and facilitate innovation and entrepreneurship and to reduce the costs of enterprise failure, it is not surprising Australia’s insolvency regime has come under scrutiny. 

When compared to other jurisdictions such as the US, Canada, NZ and the UK, Australia’s current insolvent trading regime is one of the harshest.

Can we draw a link between the country’s current regime (which has been criticised for putting too much focus on penalising and stigmatising failures) and a business community that feels stifled when it comes to taking on risk and embracing innovation? We think we can.

REFORM

The decision by the Turnbull Government to embark upon the most significant reform to Australia’s insolvency laws for over 20 years has been embraced by many.

One of the key features of the government’s ‘Improving bankruptcy and insolvency laws’ proposals paper is the introduction of a so-called insolvent trading ‘safe harbour’. 

Under the current insolvent trading regime, directors may be personally liable for all debts incurred by the company while the company is insolvent. Directors may also incur criminal liability for such insolvent trading in circumstances where the trading is held to be reckless.

The twilight zone during which directors are exposed to insolvent trading liability can be significant as even a company with plenty of cash can be insolvent if it has an existing liability falling due in the future which it cannot pay.

This creates a prickly dilemma for directors who are attempting to save the business because they will be personally liable if that attempt fails.

The facts are that in the eyes of directors and creditors alike the insolvent trading regime in Australia has been failing them. ASIC data indicates that insolvent trading in Australia, at the expense of creditors, is endemic.

However, prosecution levels are very low owing to difficulties associated with identifying (and proving) that the company was insolvent at any particular time. Data from the AICD/KWM Directions 2016 survey indicates the risk of personal liability for insolvent trading affects the decision making of directors and is likely to be a driver of the high rate of director resignations from distressed companies and the reluctance of experienced directors to accept board positions with start-ups.

So what is the solution? How can innovation in the boardroom be encouraged during the twilight zone when it is needed most?

SAFE HAVEN

The Government has proposed the introduction of a safe harbour to provide directors with immunity from personal liability for insolvent trading if they appoint a restructuring advisor to develop a turnaround plan for the company.

But how safe is the harbour? From directors’ perspective, it would provide some additional protection to directors who are genuinely attempting to turn around or restructure the company should that attempt subsequently fail (although if the safe harbour is not activated early enough directors may still be exposed).

However, from creditors’ perspective it is far from safe.  Once the safe harbour has been invoked by the board, directors can cause the company to incur debts, which the directors know the company does not have the ability to pay, with impunity. Therefore, creditors will pay a higher price if the restructure fails.

This may be a price worth paying if the safe harbour facilitates restructuring activity and results in greater innovation in the boardroom. However, the one-size fits all approach of requiring directors to retain a restructuring adviser in order to access the safe harbour may be constraining.

While a restructuring adviser can provide valuable advice to the board of a distressed company, it is unlikely to meet the needs of every company. Most businesses which fail are SMEs and start-ups.

For companies which are undercapitalised or failing due to inadequate cash flow, a restructuring adviser may offer little value to the business. Also, directors already have a clear duty to obtain appropriate expert advice and to direct in the best interests of the company.

PATCHWORK

Ultimately, this proposed safe harbour is a patch response rather than a holistic one. The way to encourage innovation in the boardroom is to leave diligent and active directors free do everything they reasonably can to make the company flourish.

For directors to be concerning themselves with establishing protections against their own personal liability is an unnecessary distraction and an unnecessary cost.

To this end, the prohibition on insolvent trading in Australia should be narrowed and simplified. Much of the difficult dilemma faced by Australian directors would be resolved if the prohibition was limited to incurring a debt where there is no reasonable basis to expect that debt to be repaid in accordance with its terms.

This is similar to the approach taken in New Zealand in 1993, which has worked well there. It provides greater certainty for directors, because directors of distressed companies are able to avoid liability by carefully managing their company’s cash flow while the directors develop and pursue a turnaround strategy or a restructure.

This approach also protects creditors in that it should ensure that debts incurred by a distressed company in the twilight zone are generally repaid.

Samantha Kinsey and Tony Troiani are Restructuring & Insolvency Partners at global law firm, King & Wood Mallesons