Voluntary administration and the evolving judicial approach to the reallocation of financial risk in the face of COVID-19

Introduction

Under Australian law, voluntary administration is intended to be a fast and efficient process to facilitate the restructuring, sale or, if necessary, liquidation of an insolvent company. The objective of the process is the maximisation of the chances of the company, or as much as possible of its business, continuing in existence or, if that is not possible, results in a better return to creditors and members than would be achieved by an immediate winding up of the company. 

A key benefit of the Australian administration process is flexibility and the ability to reach a variety of outcomes. The process is controlled by an insolvency professional who, pursuant to the Corporations Act 2001 (Cth) (“Act”), is personally liable for the debts of the company that are incurred during its voluntary administration. This includes rents for leased property, which is used or retained after an initial period of five days from the commencement of the administration, referred to as the ‘grace period’. 

The burden of personal liability for insolvency professionals weighs heavy and where the assets of the company may be insufficient to meet future debts, the prospect of the company continuing to trade and avoiding liquidation may be adversely impacted. However, reflecting the flexibility of the process, the law responds by permitting voluntary administrators to seek relief from the Court in respect of any obligations that may apply in a voluntary administration (colloquially known as "447A orders”).

These orders can both exclude or limit a voluntary administrator’s personal liability for debts and also permit the deferral of rental payments. Such orders represent a material shift in the usual allocation of financial risk in a voluntary administration. They are potentially detrimental to landlords and lessors as debts owed to them increase, without the benefit of the usual priority that post-appointment debts, for which the administrator also is personally liable, would be afforded and without the ability to take other steps to recover their property due to the statutory moratorium. As a consequence, they have been historically rare. 

However, the COVID-19 pandemic and the challenge it imposes on businesses and the economy as a whole is without doubt unprecedented. It has implications on a global scale. While legislative responses to this crisis have been well documented, it is becoming increasingly apparent that the Courts, across a multitude of jurisdictions, will also have an important role to play in seeking to ensure business survival.

We will explore approaches taken by Australian Courts in relieving administrators of personal liability for payment of rent and the deferral of rent. Further, we will consider whether these decisions demonstrate a willingness of the Courts to respond to the unique circumstances arising from COVID-19, by facilitating the external administration of companies in a way that is unprecedented with a focus on broader economic interests as well as the interests of creditors. 

Relief against personal liability and deferral of rent

Section 447A of the Act affords the Courts the power to “make any such order as it thinks appropriate about how this Part is to operate in relation to a particular company”. 

In recent years, applications under this section generally have become a common feature of voluntary administrations as it affords the Court incredibly broad powers in relation to the assets and liabilities of an insolvent company. However, orders extending the grace period before administrators become personally liable for rent or other liabilities and consequent orders for the deferral of rent have been less commonly obtained. 

Voluntary administration is intended to be a swift and efficient regime so to depart from the usual rule, the Court has to be satisfied that there is a good reason for the extension and that the extension will result in a better outcome for creditors as a whole. 

The rationale for extending the initial grace period is generally that the administrators are unable to make a decision as to whether it was in the interests of the company to continue to use or occupy the leased property within the prescribed five-day period. This might be based on the size and complexity of the administration or some other practical obstacle to the administrators deciding to accept personal liability for the relevant leased property.

In agreeing to the deferment of rent or the relief of personal liability for rent, the Court has always had particular regard to the risk of potential prejudice to lessors and landlords. In particular, the potential for the outstanding liability owed to the landlords and lessors to materially increase in circumstances where recourse is limited to the insolvent entity, without assurance of payment in priority to any other creditors. 

Increasing applications for relief

Pre-COVID-19, whilst applications for extensions of the initial grace period were not novel, there were less than a dozen written judgments in the last ten years. However, post-COVID-19, there have been four judgments in as many weeks and it must be expected that there will be many more to come.

What is clear from these four recent decisions is that the existing principles about whether a timely assessment of leased assets could reasonably be conducted by the administrators within the grace period and whether the extension was likely to assist with achieving the objectives of the voluntary administration continue to be of primary relevance.  

However, in reaching its decision in Eagle in the matter of Techfront Australia Pty Limited (administrators appointed), the Court acknowledged that it was apparent that public institutions such as the Court must do all they can to facilitate the continuation of the economy. The business in question operated in an industry that had been significantly adversely affected by government restrictions imposed due to COVID-19 and the Court had due regard to the difficulties faced by it. 

This may reflect an interesting extension to the reasoning applied in pre-COVID cases where a key consideration was the ultimate benefit to creditors and stakeholders. It is arguable that the Courts will now also take into consideration not just public interest, but also specifically the benefit to the economy as a whole by ensuring business survival, notwithstanding the prejudice particular orders may cause to lessors and landlords in the short term. 

The powers of the Court were again tested following the appointment of voluntary administrators to the Virgin Australia Airlines Group, which operates a passenger and cargo airline business domestically and internationally. 

The administrators were granted a four-week extension of the grace period, in light of the size and complexity of the Virgin’s affairs and extensive lease holdings, and delays caused by the restrictions imposed by State and Federal governments to control the spread of COVID-19.

In reaching its decision, the Court commented that:

“The COVID-19 pandemic is causing great disruption to the whole Australian community and the economy…….the COVID 19 pandemic, and the consequent restrictions on the movement and behaviour of people, is a reason to apply flexibility in the application (and perhaps adaptation) of existing laws, and to exercise any discretion residing in a court to ensure that the Australian community and economy are supported during this time of crisis.”

And it is not just new voluntary administrations where assistance is needed

The COVID-19 circumstances have not only impacted new voluntary administrations but the broad and extensive disruption to normal service has led to issues arising in existing voluntary administrations which have required the assistance of the Court in relation to personal liability for rent and the deferment of rental payments. 

In January 2020, the Colette Group, a mid market fashion accessories retailer, appointed voluntary administrators. The administrators continued to trade the business, closing only around a quarter of the Australian stores. 

The administrators initially met lease obligations after the expiry of the five-day grace period as they sought to sell or recapitalise the business. However, despite initial strong interest, by late March, all interested parties withdrew from the process, due primarily to the impact of COVID-19, as sales had suffered a significant decline and stores had closed. 

The administrators found themselves in the unenviable position where they remained in possession of the remaining stores but could not trade, with a monthly rental liability in excess of A$1 million. The administrators approached the Court seeking relief and the extension of the grace period. 

In a novel application of its powers, the Federal Court initially made orders excluding the personal liability of the administrators for an additional two-week period despite the grace period having long expired and the administrators having been paying rent. 

The administrators were also excused from having to cause the company to pay rent during that period, giving the administrators comfort against a possible claim of unreasonable or improper conduct in the future. Subsequently, on the further application of the voluntary administrators, the period was extended by a further three weeks (on similar terms). 

Noting the extraordinary circumstances caused by COVID-19, the Court accepted that the administrators’ strategy of ‘mothballing’ the business for two months was likely to lead to a better outcome for creditors as a whole than the immediate shut down of the business, particularly while the “physical, legal and economic landscape” continued to evolve. 

The evidence before the Court indicated that the administrators had attempted to negotiate a rental reduction with landlords but these attempts had not resulted in a substantial rental saving and at that time, it was unclear what form any government intervention in respect of commercial lease liabilities would take, but it was unlikely to extend to a suspension of the administrators’ personal liability. 

The Court considered that the extension was in the best interests of creditors as a whole as it was unlikely that the lessors would be able to re-lease the premises for the extended period and there was no value to the lessors in the immediate shut down modelling performed by the administrators. The Court was satisfied that the orders preserved the prospect that a commercial outcome could later be achieved in the “mothballing” scenario. 

Similar considerations arose in the hearing for a second extension. The Court accepted the administrators’ evidence that the best prospect for maximising a return to creditors remained the ‘mothballing’ scenario to allow for a managed winding down or sale as opposed to the immediate shut down scenario. This was supported by evidence that there had been progress in the sale process in that original and new parties had come forward and expressed interest in acquiring the business.

In the Colette Group decisions, consistent with its usual approach, the Court assessed the applications with the objectives of voluntary administration in mind: would the order sought give rise to a prospect of a better return to creditors? However, there is a shift in the way that the Court has allowed applications of extensions of the grace period to be made in that the orders were made some weeks after the initial five-day grace period had expired, after the administrators had decided to continue the leases and after they had accepted personal liability for payments due under them. 

It is not yet clear, whether and in what other situations the Court might be prepared to grant relief for liabilities already adopted by the voluntary administrator, as a consequence of the impact of COVID-19 on the business in voluntary administration. However, it would be reasonable to conclude that the Court’s powers to grant relief are likely to be tested at this time. 

Commercial Leasing Principles  

Another as yet untested question relevant to the issue of liability for rental payments and the deferral of rental payments is how the various interim legislative changes for commercial leasing might impact the availability of relief and the ability of a landlord to be able to demonstrate sufficient prejudice. 

Between the first and second applications in the Colette Group, the Australian National Cabinet (being a cabinet comprising the state and territory governments) had released the “Mandatory Code of Conduct – SME Commercial Leasing Principles During COVID-19” (“Code”) and agreed that it would be legislated in each Australian state. As at the time of writing steps have been taken to enact the Code to some extent in all but one of the Australian states and territories. 

While the specifics of how the Code is to be applied vary from state to state, the Code sets out guiding principles for consideration by landlords when dealing with eligible tenants. The overarching principles of the Code include the concept that landlords and tenants share a common interest to ensure business continuity. 

Eligible tenants are those with an annual turnover of up to A$50 million who are experiencing financial distress or hardship as a consequence of COVID-19. The Code requires a landlord to provide rental relief to a qualifying tenant by the same proportion as the loss of revenue experienced by the tenant by way of rental waiver and deferral of rent. It also prevents landlords from terminating leases or calling on bank guarantees for unpaid rent. 

While this was yet to be enacted by any Australian state and territory at the time of the second Colette Group decision, it was noted that the Code could impact the liability that could accrue as there may be a material difference in the rent payable under the leases and the rent payable under the Code but did not comment on how that might impact the orders it would be prepared to make. 

The mandated package provides a significant level of protection for tenants and leaves landlords without much by way of immediate leverage (as they are precluded from calling on bank guarantees or terminating leases). However, it does not in itself relieve a voluntary administrator of personal liability for the balance of the rental payments that may still be due and other outgoings. 

It remains to be seen precisely how the Courts will exercise its broad discretion to grant relief such as in the matters of Virgin and the Colette Group, where the company in question is eligible for the protection of the Code. 

One has to expect that it will become increasingly difficult in this circumstance for landlords to argue that they have been prejudiced by a decision of the Court to relieve an administrator of personal liability or defer rental payments, if they are otherwise obliged to provide relief to tenants under the Code and are already sharing the pain to ensure business continuity. 

What about other jurisdictions 

It is not just in Australia where the Courts are attempting to provide practical assistance to insolvency professionals and companies in an insolvency process during the COVID-19 pandemic. 

In the United States, certain retailers in chapter 11 cases have confronted similar issues. In In Re Modell's Sporting Goods, Inc., the US Bankruptcy Court for the District of New Jersey suspended the chapter 11 cases of the company, a sporting goods retailer that was shutting down. The impact of the government’s response to the COVID-19 pandemic meant that Modell’s was unable to generate sufficient revenue to conduct an orderly going out of business and asset sale process. Emergency relief was granted under section 365(d)(3) of the US Bankruptcy Code, which permitted Modell to abate rent and other lease obligations for a period in excess of the statutory limit provided for under the Bankruptcy Code. 

An article exploring a similar decision of the United Kingdom Court of Appeal also appears in this edition of Insolvency Newswire and provides an interesting comparison. 

Conclusion

If the last two months provide any indication, it appears that the voluntary administration process and the powers of the Court under section 447A of the Act will be tested frequently and potentially beyond their existing limits. 

Decisions made by administrators before the COVID-19 pandemic may need to be reassessed and the assistance of the Court sought to ensure the objectives of the voluntary administration process can be achieved. This may not only relate to decisions to accept personal liability for leased assets after the end of the grace period. 

Landlords may find that it is increasingly difficult given the COVID-19 circumstances to demonstrate sufficient prejudice so as to avoid orders deferring rent and relieving personal liability being made. Administrators hold a strategically strong position in that if negotiations with landlords fail there remains an option of an application to the Court to ensure a better ultimate return to all creditors. However, landlords may find power in working together to agree protocols and regimes with the administrators or seeking a limited personal liability arrangement to ensure any rental payments enjoy priority to the extent there are available assets. 

More broadly, post-COVID-19, stakeholders can expect the Court to have consideration as to how the exercise of its discretion will best ensure that the Australian community and economy are supported in these extraordinary times.