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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.

 

Directors and their safe harbour – how to get them to behave

An aim of the latest “safe harbour” insolvency reforms is to “drive cultural change” in company directors by encouraging them to keep control of their company with a view to working on its recovery, rather than simply putting the company into a formal insolvency administration. While changing the law will assist, much more beyond that is required.

It is a tall order, that a change of words in a law will influence directors to act earlier and more effectively in the face of financial difficulty.   

The law is obviously an influence on culture (however that may be defined), including how the law is promoted, and applied, and enforced, all over a period of time. The law of insolvent trading under s 588G of the Corporations Act has come over time to be demonised by lawyers as overly harsh and an impediment to constructive director behaviour; even though, on the figures, others might more accurately regard the likelihood of liability being imposed as inconsequential.

Behavioural economics

In that respect, the recent Academy of Law debate raised the issue of the limits of what the law itself can achieve, and introduced behavioural economics into the debate in order to explain that.

Behavioural economics and its related disciplines seem to be necessary to assess the potential effectiveness of these safe harbour law reforms if a change in culture and director behaviour is the aim.

This is a list of some of the effects behavioural economics has shown that influence directors faced with their business’ financial distress, often adversely to what the law intends or requires.

  • The endowment effect, whereby a director develops an attachment to a business, in particular where equity is owned, and perceives its value to be higher when asked to part with it.  Total SME ownership would involve attachment to a higher level. 
  • Commitment bias, being an increased commitment to an endeavour when it is failing, involving a failure to admit past mistakes and an aversion to face pending loss. 
  • Status quo bias, being an inherent bias to carrying on as usual, even when faced with a crisis, in particular where the perceived loss sought to be addressed is significant.
  • Ethical dilemmas, whereby legal ambiguity facilitates wrongdoing as directors construct self-serving interpretations of the law, with unethical behaviour being rationalised by the norms of the type of business in which the directors operate. 

These points were offered to explain the hesitation of directors to put their company into voluntary administration, and to find excuses and rationales not to.[1] In contrast, more positive influences are said to arise where the directors are able to remain “in possession”, even if under some control or guidance, to themselves try to restructure their failing business.

The mind of the director

When one enters the mind of a director who is told that a liquidation or a Part 5.3A administration involves them losing control of their business – staff, creditors, suppliers and goodwill – in favour of an unknown ‘independent’ administrator whose role is to investigate their conduct and consider whether any wrong-doing has occurred, and report it, and maybe pursue it in court, one can understand why some directors might indeed hesitate.

The safety of the harbour

To some extent the safe harbour reforms seek to ameliorate that sense of hesitation.  The director would remain in control, under the guidance and assistance of an adviser, and both together, some way out of the predicament is achieved. Similar thinking exists in the proposed European restructuring reforms.

The director knows that he or she is protected from later liability. But perhaps more importantly the director has the benefit of a supportive adviser retained by them, rather than an unknown and potentially adversary administrator. That adviser needs to be appropriately qualified to assist, again an assessment the director might be more ready to make from existing contacts, rather than what might be a further inhibition of being limited to an adviser from a nominated pool.

This seems satisfactory from a behavioural perspective, to a point.  But it does require professional promotion and positive support, which may or may not be adequate from existing sources.  If the professions were to promote the change positively, with the same vigour that some spoke negatively of section 588G, some success in changing culture might be achieved.    

The open seas

But the earlier period of time is not really addressed by the these proposed reforms, when a director, in operating a business on the high seas, should acknowledge, from experience and observation, that the success of the business requires objective measures to be put in place to forewarn of rough weather. Mechanisms are needed to address indications of financial decline, or less than optimum performance, on an on-going basis, preferably with appropriate advice.  

Behavioural studies may well have some answers on how that preventive culture be engendered while a business is operating in the open seas, without the pressure of directors suddenly having to find a section 588GA safe harbour; although it can also be said that poor preparation for the high seas may count against the safe harbour being later accessible. 

What proposed s 588GA offers

As much as the safe harbour reforms seem to offer are that, at some point in time, when things start to go bad, the directors can suddenly be prompted to act, and seek refuge in their harbour.  That is useful, in bringing forward in time the directors’ focus from what presently is often too late a time, the brink.

It would be better if the law, in some way, could instil a preventive and monitoring culture that prompts earlier action well before that.  

The task of others

But the law has its limits. The task in that earlier time period on the open seas lies not so much with the law, as with the professions, to promote to clients the need for on-going financial monitoring and controls, and offer ready assistance in times of stress or decline. 

And this view may be unfair, or incorrect, but it seems there is little focus on the need for that advice in accountants’ marketing, beyond tax, and much preaching to the converted. A casual read of accounting and trade journals supports that.

As a simplistic but telling comment, a new text book on law for those in business, authoritative and otherwise comprehensive in its 1000 pages, devotes just 15 pages to business decline and insolvency. 

People just don’t want to know about failure and loss, and behaviourists rather than the law might be better able to advise on how the law, or other disciplines, can be applied to instill a culture of preparation for its occurrence.  

 

[1] A law honours thesis of a colleague has provided me with thoughts and information on behavioural economics, for which due acknowledgement is given.  Details are available on request.

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