Michael.1
Insolvency and related law and policy, and more

Michael Murray is an Australian author and commentator on corporate and personal insolvency law and related issues, in Australia and internationally. He has a strong law and policy background, is independent of any connections, and his views are his own. He gives no legal advice. 

Safe harbour – some inherent behavioural issues to overcome

While the new safe harbour law[1] is the end result of some years of torturous debate, still on-going, it is also only the start of what needs to be an on-going effort of trying to ensure its acceptance and application. 

The first task is to understand and explain that mere words in the new section 588GA or any statute are not enough when the law is aimed at changing behaviours and the conduct of individuals. In this context, those people are directors and boards, as well as regulators, creditors and the community.

A cultural and attitudinal shift is needed as well, and that is the harder part. Many will resist the shift required.

Behaviour

This brings in disciplines well beyond the law. Whether from those behavioural disciplines, or our own experience, we should be aware that many factors play upon personal and business behaviour, both at the core of safe harbour.

Some of the effects behavioural economics has shown that influence business owners faced with their business’ financial distress are these:

  • The endowment effect, whereby a person has an emotional bias such that they are more attached to a business that they own themselves, and go on to perceive its value to be higher when required to part with it. Challenges over value by business owners in liquidation and receivership sales are common, but invariably the owner is not successful.
  • Commitment bias, being a tendency to consistency with a person’s stated positions, which can both lead to an increased commitment to a business when it is failing, and an aversion to admitting past mistakes and to facing pending loss.
  • Status quo bias, being an inherent bias to carrying on as usual, even when faced with a crisis, perversely reinforced when a looming loss is significant.

Then there are ethical dilemmas, whereby directors take advantage of inherent legal ambiguity and construct self-serving interpretations of the law and of their obligations. Their behaviour is often rationalised by the norms of the type of business in which they operate. There are also self-serving biases of overconfidence and optimism present in most people, such that crises – a failing business – are not seen objectively, but rather, unrealistically.

The external pressures are also there.  A business often provides a person their social standing, and support of themselves and their family. While one might objectively say that these factors should engender care and attention, they can perversely have the opposite effect.  Psychological biases and mental shortcuts can lead to financially unsound decisions.  Complex variables and ambiguous, unpredictable consequences of any given choice – see section 588GA – may lead to the director being psychologically overwhelmed.

Australian attitude to unpaid debt

Our own culture, to the extent it can properly be defined, is also to be taken into account.  In common with comparable societies with strong contract law, abiding by one’s obligations is the expected norm. Those who fail to honour their debts earn disrespect, and more, however much of a “go” they had at their enterprise. Poppy King has recently recounted her experience with Australian culture.

But while safe harbour may require creditors to adjust as well, there are limits. Director (mis)behaviour is often displayed in court judgments, with judges well attuned to analysing what happened in both legal and human terms. An example is found in these judicial comments:[2]

94 There cannot be the slightest doubt that, at least by mid 1992, [the company] was hopelessly insolvent and that its situation did not ever recover in a significant degree. The various extracts from the minutes which I have recited, considered in light of the progressive financial statements speak eloquently for themselves. As [the director] conceded in evidence, it was realised by the directors that they were incurring debts which they were not in a position to pay …

Their attitude was that they

were confident, if we could survive the recession, we would be a successful company“.

When he was asked

But how could you possibly, given the situation that your managing director had stopped purchasing, as he believed he could not legally do so and give the situation that it had been recorded a couple of months earlier in the minutes that you had no orders, how could you possibly continue trading?”,

his response was

… we were looking for ways of raising further capital“.

95 The compelling inference arising on the evidence was that the directors plainly adopted what, to any dispassionate observer at the time, was a quite unrealistic “Micawber” like stance – hoping against hope that something would turn up to resolve their difficulties. This persisted over a very long period of time and any honest appraisal by them of the situation must have caused them to realize that they were whistling against the financial wind.

96 I do not think it could ever seriously have been believed by any of them that there was ever any general agreement by their creditors for extended terms of trade. What was occurring was plainly a constant juggling of what funds were available to satisfy those creditors who pressed hard, leaving the less aggressive creditors simply to wither on the vine.

The law and culture at present

These comments are offered to explain the variety of influences impacting upon a business owner that may explain their inability to face up to their business’ slow or rapid decline, and seek advice.

At present, what directors may be told is to seek advice from an “insolvency” specialist, a “liquidator”, the connotations of which can be seen as negative.

Apart from what some directors may see as a daunting meeting, the director is then told that an insolvency involves them losing control of the business – staff, creditors, suppliers and goodwill – in favour of an unknown ‘adviser’ who will not, lest it compromise their independence later, give them the full story.

What story is offered is that this insolvency specialist is so independent and impartial as to be required to investigate the director’s conduct and consider whether any wrong-doing has occurred, and report it, and maybe pursue it in court; and possibly pursue the director’s creditors and associates.

One can understand why some directors might indeed hesitate, or go to an ‘alternative’ adviser.

What s 588GA offers

To some extent the safe harbour reforms seek to ameliorate that hesitation.  The director remains in control, under the guidance and assistance of an adviser, and together, some way out of the predicament is examined.

The long decried “debtor in possession” scenario is now an option.

The director also 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 need be appropriately qualified to assist, again an assessment the director might be more ready to make from existing contacts, rather than what some sought as the further inhibition of being limited to an adviser from a nominated pool.

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 the directors’ focus from what presently is often the brink.

The limits of the law

But it would be better if the law, in some way, could instil a preventive and monitoring culture that prompts earlier action well before that, through promoting attention to on-going financial governance.

This is where the law really has its limits. The task in that earlier time period lies not so much with the law, as with the professions, in particular accounting, and the regulators, to promote and sell to business clients the need for on-going financial monitoring and controls, and to offer ready assistance in times of stress or decline.

Behavioural approaches adopted in relation to the need for regular health screening, where there has been a significant and beneficial cultural shift, might be considered; as well as those used by the ATO, AFSA and ASIC.

Bringing creditor groups on side, and banks, also needs similar attention.

None of us really want to know about failure and loss, and behaviourists rather than lawyers and accountants may well have better answers on how that preventive culture be engendered in people in business, well before the pressure of suddenly having to find a section 588GA safe harbour. That work needs to be done to ensure the safe harbour reforms meet their purpose.

(For those interested, see Behavioural Economics, Over-indebtedness & Comparative Consumer Bankruptcy: Searching for Causes and Evaluating Solutions, Jason J Kilborn, (2005) 22 Emory Bankruptcy Developments Journal 13. And other related articles).

[1] Treasury Laws Amendment (2017 Enterprise Incentives No 2) Bill 2017

[2] Powell & Duncan (Noelex Yachts Aust) v Fryer [2001] SASC 59

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