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Michael Murray’s on-going commentary on issues in corporate and personal insolvency law and related policy and law reform, in Australia and internationally. Given the scope of insolvency, this extends to business, consumer and professional conduct, and ethics, governance and regulation, criminal, tax, environmental and administrative law, and the courts and government.

 

Law reform – a carve-out from directors’ insolvent trading liability, with a change in their culture in return

The draft ‘safe harbour’ provisions proposed by the government offer directors two advantages in what must be their genuine attempts to save their business. A consequence is that the liquidator, waiting in the background if things do not go as planned, takes on an extra burden in any pursuit of those directors, save for one reform in the liquidator’s favour.

That is, the government has opted to:

  1. retain the prohibition on insolvent trading under s 588G;
  2. remove the current “defence” provision – s 588H – in favour of a “carve-out” – s 588GA – from insolvent trading liability;
  3. keep the onus of proof on the liquidator while placing only a lesser “evidential” onus on the directors; and, under a recently introduced reform,
  4. allow the liquidator to sell the insolvent trading claim if that is a preferable course, under s 100-5 of the Corporations Schedule. 

This overall approach is in accord with the intent of the changes, to prompt directors to more readily address the financial instability of their business without undue legal pressure, while at the same time requiring directors to work responsibly in doing so.

However the message in the reforms is to almost demonise voluntary administration, as being destructive of business value, with safe harbour offering directors whatever means they can to avoid it. One limited option to address this is the proposed restriction on the exercise of ipso facto clauses.  But no other or further options are included or discussed, perhaps because the government was so intent on pushing this singular ‘safe harbour’ idea through.  

The danger with any narrow law reform is in its unintended consequences, the reduction in the potential and use of a regulated regime under Part 5.3A, and the opening up of an unregulated space where ‘restructuring’ players will always be found to abuse it.  That is left for another commentary. 

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The retention of s 588G, with a carve-out, is important and is based on Commonwealth policy and statute law in relation to the imposition of penalties or of personal liability for corporate fault.

  1. Why keep s 588G?

A threshold point is that section s 588G would remain as is, despite the negative reputation of its perceived impact on business decisions.   

While there may be other reasons for the retention of section 588G rather than amending it, a valid drafting and policy reason is that the stated and accepted principle of any major legislative provision – here, that a director should not allow the company to trade while insolvent – comes to encompass more situations than the policy outcome was intended to cover. That can be addressed by amending the principle stated in the relevant section to bring its scope within the intended policy bounds.

But often a better approach is to retain the broader statement of principle and identify carve-outs from its operation.  “The reason for preferring the alternative approach is that the broader principle expresses the intended idea in a way that will make more sense to readers than modifying the principle. This happens when a modified principle would compromise the reader’s intuitive grasp of what the law is doing and so actually reduce reader comprehension”. Hence, the preferred course will usually be to define the carve-out (or in other cases, an extension of liability), rather than to change the principle itself: see The coherent principles approach to tax law design, Greg Pinder, Treasury. 

In other words, there is merit in leaving section 588G as it is, as an important statement of principle, and adding a carve out; rather than trying to amend and ‘soften’ s 588G with a carve out.

This method also gives the carve-out criteria greater emphasis:

  • taking appropriate steps to prevent any misconduct by officers or employees of the company that could adversely affect the company’s ability to pay all its debts;  
  • taking appropriate steps to ensure that the company is keeping appropriate financial records consistent with the size and nature of the company;  
  • obtaining appropriate advice from an appropriately qualified entity who was given sufficient information to give appropriate advice;
  • properly informing himself or herself of the company’s financial position;
  • developing or implementing a plan for restructuring the company to improve its financial position.
  1. Why a carve-out rather than a defence?

Burdens of proof

In relation to those carve-out criteria, the director would have the evidential burden of proving them.  An evidential burden means

“the burden of adducing or pointing to evidence that suggests a reasonable possibility that the matter exists or does not exist”.

In contrast, a “legal burden” of proof, on the balance of probabilities, means

the burden of proving the existence of the matter”.

If that evidential burden is discharged by a director under s 588GA, to quite a low threshold, what has been called the ‘deferred’ legal burden of proof remains with the liquidator to prove that the director has breached s 588G and has not met the carve-out requirements of s 588GA.

  1. Defence v carve-out

The essence of a carve-out is based on the broad policy that it is generally for the prosecutor (liquidator) to prove its case; but in some cases, the defendant will be more aware of their own circumstances than the prosecutor, hence the law imposes some onus on the defendant, not too much, to explain them.

In terms of the policy approach taken by the government of encouraging early or preventive action by directors, they not only have the carve out, but a lesser standard of proof to get there. A liquidator thus has a higher standard to prove if director liability is pursued. That all appears to accord with the policy objective with its focus on director conduct.

  1. What is the liquidator now left with?

If the directors’ company ends up in liquidation, despite their efforts to save it, a liquidator will now have to assess the directors’ conduct in light of the usual evidence in support of s 588G, and in light of what the directors did, in whole or in part, in accord with the criteria in s 588GA.  If that means it will be harder for liquidators to pursue directors under s 588G, that is accepted as a necessary consequence of the new flexibility allowed to directors. 

The government policy accepts that it is better overall to offer that incentive to directors, and to lessen the threats currently involved in a liquidator later finding fault with their conduct and pursuing them for insolvent trading.  Overall, creditors, and businesses, should be better off.

Under section 100-5 of the Corporations Schedule, a liquidator may now ‘assign’ or sell a section 588G claim. One circumstance may be that the liquidator has no funds to bring the claim, or the liquidator, in consultation with the creditors, is not willing to risk what funds are available. The claim may well be valid and be of value to a purchaser.

However, in light of the proposed section 588GA, such claims will be more problematic and hence of less value. A liquidator’s attempt to negotiate payment from directors for claimed breach of s 588G will now be more difficult.

But to repeat, that is an accepted outcome of the increased support now offered directors in their restructuring efforts.

The real purpose of the change in the law

Litigation, and directors’ reliance on section 588GA, is only in the government’s fall-back scenario, when, despite best efforts, or not so good efforts, the business succumbs to the “value destructive” Part 5.3A or liquidation regime. 

The government is really saying that this change in the law is meant to prevent that scenario, by way of causing a change in business culture, in favour of early attention being given to a business’ decline, by directors acting in accord with the carve-out criteria. 

Unfortunately, a change of business culture will not be effected simply by words being added to or removed from the law, particularly in relation to the distant threat of an insolvent trading liability.

That is not to say that the reform is not worthwhile.  But more depends on how the reforms are ‘sold’, and supported, not in terms of the legal complexities described, but as a checklist of what a business should do when financial decline starts, with some comfort and encouragement to directors that not only will attention to this list protect them, but it may also save their business.

That selling of the reforms, if they proceed, needs to be undertaken by the government and the regulators, and the relevant professional and trade bodies. It also needs to be supported by “appropriate advice from an appropriately qualified entity”, which, in light of what business and accounting advice is available in the MSME market at least, is lacking.  That carve-out criteria under s 588GA involve expenditure on advice when company funds are under pressure. Government assisted financial counselling for small business is an option to change that culture, in the same way that financial counselling has done so for individuals. 

The more difficult issue lies outside insolvency law and the law itself, that is, the inherent human tendency of business owners to unrealistically try to ‘toughen it out.’ Countering this requires a more subtle approach than merely changing insolvency law, and pursuing the directors some years later for insolvent trading. 

Removing some of the impediments to the use of Part 5.3A, for example by allowing a debtor in possession model, might be considered.   Changes to other laws in favour of creditors – single touch payroll recovery, corporate transparency through director identity numbers and beneficial ownership – are needed, to keep businesses honest and compliant. The PPSA is an example of a beneficial influence on business culture.

Other disciplines

The change in culture also needs the enlistment of other disciplines, such as behavioural economics and business psychology, to support the implementation of the legal and policy intent of these proposed new laws. Various behavioural theories can be used to show, for example, that a status quo bias in decision making, or an increased commitment bias to a struggling business, might be alleviated by a debtor in possession model, rather than the dramatic loss of control involved in appointing an administrator. 

Deadline for comment

The government asks for comment on the proposal by Monday 24 Aril 2017. 

This analysis may assist in assessing and commenting on the proposals.

 

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