Key points
- Directors have been temporarily relieved of their duty to prevent insolvent trading during the COVID-19 pandemic.
- That relief is scheduled to expire on 31 December 2020.
- Many commentators believe that directors can only avail themselves of the temporary relief if they appoint a liquidator or administrator before the moratorium expires.
- Directors of companies at risk of insolvency should seek legal advice regarding their potential liability.
The Government’s response to the pandemic
In March 2020, as part of its response to the pandemic, the Federal Government passed the Coronavirus Economic Response Package Omnibus Act 2020 (Cth) (Coronavirus Response Act).
The Coronavirus Response Act temporarily amended Australia’s insolvency laws, to provide flexibility for companies and individuals facing short-term financial difficulties during the pandemic.
The Explanatory Memorandum to the Coronavirus Response Act, stated “[T]he economic impacts of the Coronavirus could see numerous individuals at risk of bankruptcy and Australian businesses at risk of insolvency. To avoid unnecessary bankruptcies and insolvencies… this Bill provides a safety net to help businesses to continue to operate during a temporary period of illiquidity, rather than enter voluntary administration or liquidation; and a safety net to individuals to assist them with managing debt and avoiding bankruptcy.”
Duty to prevent insolvent trading
The Coronavirus Response Act temporarily relieved directors of their personal duty to prevent insolvent trading. Here’s our breakdown of the Act which we wrote at the time.
Pursuant to section 588G of the Corporations Act 2001 (Cth) (Act), insolvent trading occurs when:
- a company incurs a debt;
- the company is insolvent at the time of incurring the debt (or becomes insolvent due to incurring that debt); and
- there are reasonable grounds for suspecting that the company is insolvent or would become insolvent due to incurring the debt.
Solvency is defined in section 95A(1) of the Act as the ability to pay all debts as and when they become payable.
A director who fails to prevent a company from incurring a debt, while aware that there are reasonable grounds for suspecting insolvent trading (or in circumstances where a reasonable person in a like position would have been aware of reasonable grounds) contravenes section 588G(2) of the Act.
As a result, the director may be personally liable to pay compensation (s 588J) or a pecuniary penalty (s 1317G) or may be disqualified from managing corporations (s 206C).
A director can defend a contravention proceeding if:
- the director had reasonable grounds to believe that the company was solvent;
- did not take part in the management of the company; or
- took all reasonable steps to prevent the debt from occurring (s 588H).
A director may also be protected by ‘safe harbour’ provisions, if debts are incurred while the company implements a course of action which is reasonably likely to lead to a better outcome than external administration (s 588GA).
Temporary safe harbour
The Coronavirus Response Act created a new safe harbour to temporarily relieve directors of their duty to prevent insolvent trading during the pandemic.
The newly created section 588GAAA of the Act states:
- Subsection 588G(2) does not apply in relation to a person and a debt incurred by a company if the debt is incurred:
(a) in the ordinary course of the company's business; and
(b) during:
(i) the 6-month period starting on the day this section commences; or
(ii) any longer period that starts on the day this section commences and that is prescribed by the regulations for the purposes of this subparagraph; and
(c) before any appointment during that period of an administrator, or liquidator, of the company.
The moratorium period began on 25 March 2020 and is due to expire on 31 December 2020 (although the Government may elect to extend this period).
Many directors with companies impacted by the pandemic have continued to trade during the moratorium period, under the assumed protection of this provision.
Time for appointing an administrator or liquidator
Despite the widespread reliance on the temporary safe harbour, section 588GAAA(1)(c) is clumsily worded and has been the subject of much legal commentary.
On one view, section 588GAAA(1)(c) requires directors to appoint an administrator or liquidator before the end of the moratorium period (currently 31 December 2020) to benefit from the safe harbour. Accordingly, based on that view, if a company does not appoint an external administrator before the end of the year, a director may be personally liable for insolvent trading during the moratorium period.
Other commentators say the provision simply means that if an external administrator is appointed during the moratorium period, the safe harbour will not apply to any debt incurred subsequent to that appointment. In our view, this is the better interpretation of the provision, considering the underlying purpose of the Coronavirus Response Act.
The modern approach to statutory interpretation allows a court to consider the context and purpose of a statue, which may lead to a construction that departs from the ordinary meaning of the words used.
The explanatory memorandum does not provide any clarification of the clumsy wording.
Often when legislation is passed, there is a subsequent period of uncertainty surrounding its interpretation.
It falls to the courts to resolve this uncertainty, when a case is eventually brought before them which requires judicial interpretation of the new law.
In this case, however, the issue is unlikely to come before the courts before the moratorium expires, and directors are left in a position of uncertainty.
Several bodies have made representations to the Government, seeking legislative clarification on this issue.
The relief is temporary
The reality of the COVID-19 pandemic is that during the moratorium period many companies have not had the ability to pay their debts as and when they fall due.
The temporary safe harbour (along with other temporary measures which have extended the time a company has to respond to a statutory demand) has meant that companies, which may otherwise be forced into administration or liquidation, have continued to trade.
But these temporary measures cannot continue indefinitely, and many companies are likely to be wound up when the temporary protections expire.
In anticipation of this, the Treasury has announced it intends to reform insolvency law for small businesses from 1 January 2021. The full details of this reform have not yet been revealed. However, the Treasury has indicated the changes will enable small businesses to quickly restructure debt, while allowing owners to remain in control of their businesses. The liquidation regime for small businesses will also be streamlined.
Risk for directors
The poor drafting of section 588GAAA(1)(c) may mean that if a company does not appoint an external administrator by 31 December 2020, and is subsequently wound up, directors may be personally liable for debts incurred during the moratorium period. We think the better view is that the appointment can occur post 1 January 2021 and directors will be protected. In view of the uncertainty it is incumbent on the Government to clarify the issue urgently.
On either view, directors will not be protected by 588GAAA for debts incurred after these temporary provisions expire.
Accordingly, from 1 January 2021, directors are at risk of personal liability if the company continues to trade while insolvent.
If a director suspects insolvency, the Act also provides safe harbour to directors who develop a course of action that is reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator, and a debt is incurred directly or indirectly in connection with such course of action (s 588GA).
The course of action should be well documented and there are conditions on the protection.
It is highly recommended that directors seeking to rely on this safe harbour, obtain advice from a qualified professional about the course of action they intend to adopt.
Directors of a company at risk of insolvency after the moratorium period should seek advice about the implications of trading into the new year.
If you would like further advice on the matters discussed in this article, please contact our Dispute Resolution team.