Insolvency law refresher for financial institutions

Overview

The pandemic has created significant financial and operating challenges for all Australian businesses. While interim government fiscal support measures, and temporary changes to the insolvency regime such as the six month suspension of insolvent trading liability for directors, have helped to calm the storm and delay mass new insolvency filings, the fiscal cliff is fast approaching and the final quarter of 2020 will see an influx of insolvencies that will last well into 2021.

In this landscape, it is important for financiers to assess the insolvency risk across their loan and investment portfolios and consider their enforcement options and liability implications to ensure they are prepared for what lies ahead.

We therefore felt it was timely to write an insolvency law ‘refresher’, setting out the key issues and risks for financiers to consider and looking ahead to what new insolvency processes may be introduced in 2020-2021 as the Commonwealth Government commences its process of legal and economic reform.

Types of insolvency processes in Australia

There are four primary formal insolvency processes in Australia:

• Liquidation;
• Voluntary administration;
• Receivership; and
• Creditors’ schemes of arrangement.

These processes are summarised in the table below.

Informal restructuring insolvent trading safe harbour

Since September 2017, directors have been able to take advantage of a safe harbour from insolvent trading liability under section 588GA of the Corporations Act 2001 (Cth) (Corporations Act), which protects them from personal responsibility for a company’s debts in circumstances where they develop and implement a dedicated informal restructuring plan acting on the advice of an appointed specialist restructuring expert.

The safe harbour is designed to encourage informal rescue attempts for viable companies which, despite current financial difficulties, have a reasonable prospect of being able to return to profitable trade in the longer-term.

By providing directors with immunity from insolvent trading liability where the conditions in section 588GA of the Corporations Act are met, the safe harbour acts as a key incentive for directors to pursue an informal rescue attempt (if the company is viable) rather than immediately appointing a voluntary administrator in an effort to invoke the defence to insolvent trading in section 588H(6).

However, the safe harbour is largely untested in the courts, and many directors do not see it as a ‘safe bet’, particularly amidst the economic and financial uncertainty of the pandemic.

In any event, there is not currently any enforcement moratorium that applies during the negotiation of an informal restructuring attempt, so major financiers and other creditors remain free to exercise their enforcement rights. When this is done, and the assets subject to a security interest comprise the bulk of a company’s primary undertaking, liquidation is usually the realistic end point for the company.

Overview of directors’ duties and implications for financiers

Apart from the duty to prevent insolvency trading under section 588G of the Corporations Act, directors in Australia owe the company core duties to act:

• With reasonable care, skill and diligence (section 180);
• In good faith in the best interests of the company (section 181);
• For a proper purpose (section 181);
• Without any conflict of duty or interest that results in a personal advantage or detriment to the company (section 182); and
• Without improperly using the company’s information to gain a personal advantage or cause detriment to the company (section 183).

These duties are owed not just by appointed directors but also shadow directors, being persons, whether individuals or companies, whose instructions or wishes are followed by appointed directors as a matter of course. A shadow directorship most typically arises in the context of a corporate group, with both a parent entity and its individual officers capable of being shadow directors, a point recently emphasised by the High Court in March 2020 in ASIC v King [2020] HCA 4.

Financiers should be careful about the risk of being found to be a shadow director, especially in the peak insolvency period ahead in circumstances where financiers elect to support an informal restructuring and their terms and conditions shape the course of the negotiations. That said, simple insistence on enforcement rights, leaving directors to exercise their own independent judgment about what is in the best interests of the company and what course the company will adopt, will not give rise to shadow director liability, as affirmed in Buzzle Operations Pty Ltd (in liq) v Apple Computer Australia Pty Ltd [2011] NSWCA 109.

Shadow directorship aside, it is important for financiers to note that the Australian courts have held that the interests of ‘the company’ in assessing the best interests duty owed by directors correlates to the interests of creditors during a period of doubtful solvency. The Bell Group litigation reflects that financiers need to be careful in negotiating new security and payment terms in a corporate group setting which benefit one group entity but sacrifice the interests of related entities. In that case, appointed directors of the related entities may breach the best interests duty, and a court may make an order invalidating the new security terms and payments received by the financier.

Insolvency law changes in response to COVID-19 and directions for future law reform

Until 25 September 2020, the Coronavirus Economic Response Package Omnibus Act 2020 (Cth):

• Extends the timeframe for companies to respond to a statutory demand to 6 months (up from the previous 21 days);
• Increases the minimum threshold debt for issuing a statutory demand to $20,000 (up from the previous $2,000); and
• Introduces a moratorium on insolvent trading liability for directors.

The Commonwealth Government is currently considering an extension to these interim measures, and also the potential for a six month prohibition on liquidators recovering unfair preference payments.

The Government is also considering deeper insolvency law structural reforms, including the possible adoption in Australia of features of the United States Chapter 11 ‘debtor in possession’ process. There is also a strong industry push for the adoption of a super priority financing regime, more extensive enforcement restrictions during a period of informal restructuring and during voluntary administration (for both secured and unsecured creditors) and greater scope for secured creditors to be ‘crammed down’ so that they are bound to a formal restructuring plan even if they do not vote in favour of it.

Reforms of this kind will directly impact on the security position and enforcement rights of financiers, and this will need to be factored into existing and future loan decisions and risk frameworks.

The law reform process in Australia will be shaped by recent measures adopted in the United Kingdom. Notably, the Corporate Insolvency and Governance Act 2020 (UK) came into force on 26 June 2020 and provides for a new ‘restructuring plan’ alternative. It is essentially like a creditors’ scheme of arrangement in Australia, but permits the court to approve the restructuring plan where one or more classes of creditors does not approve it by a 75% in value threshold. This could see dissenting secured creditors bound to a restructuring plan where that is in the best interests of creditors – and the public interest more generally in critical industries – as a whole.

The United Kingdom reforms also provide for an enforcement moratorium, binding on both secured and unsecured creditors, during the negotiation of an informal restructure. This applies for an initial 20 business day period (this can be extended) when an independent monitor forms the view that the moratorium is reasonably likely to lead to a successful restructure.

Cross-border insolvency regime

It is also important for financiers to be mindful of Australia’s cross-border insolvency regime.

Australia formally adopted the UNCITRAL Model Law on Cross-Border Insolvency (Model Law) through its enactment of the Cross-Border Insolvency Act 2008 (Cth) (CBIA).

The CBIA, and comparative legislation in other jurisdictions that have adopted the Model Law – including the United States, the United Kingdom, Canada, Japan and New Zealand – provides a streamlined process for a liquidator of a company in a Model Law jurisdiction to take control of assets of the company located overseas, as well as pursue investigations and institute recovery proceedings overseas (for example, to have voidable transactions set aside).

Essentially, this involves the liquidator (referred to under the Model Law as a ‘foreign representative’) applying to an overseas court to obtain recognition of the liquidation and a formal order permitting the liquidator to take control of foreign assets and pursue investigations and recovery proceedings in accordance with the provisions of the overseas insolvency law. In making an order, the court must be satisfied that the interests of local creditors are ‘adequately protected’.

Alternatively, section 581 of the Corporations Act sets out a mandatory obligation for Australian courts to provide assistance ‘in all external administration matters’ if they receive a letter of request from an overseas court in a ‘prescribed’ country (currently Jersey, Canada, PNG, Malaysia, New Zealand, Singapore, Switzerland, the United Kingdom and the United States). An Australian liquidator can also apply to the court to issue a letter of request to an overseas court under section 581.

Apart from the recognition provisions, the CBIA (and comparative legislation in jurisdictions that have adopted the Model Law) gives overseas creditors the same rights as local creditors to participate in insolvency proceedings by lodging a proof of debt and voting.

While the cross-border regime may expand the asset pool available for Australian financiers to enforce their claims in overseas jurisdictions, correspondingly the enforcement of claims by foreign creditors over Australian assets may impact on the security position of Australian financiers. This is a key risk issue that Australian financiers need to plan for in their enforcement strategies in coming months, with the number and scope of cross-border insolvencies likely to rise in light of the global economic and financial repercussions of the pandemic.