A safe space for directors: the ‘safe harbour’ defence to insolvent trading

On 19 September 2017, the safe harbour provisions came into force, which were introduced to the Corporations Act 2001 (Cth) (the Act) by amendment.  These amendments:

• created a defence for directors against insolvent trading known as the ‘safe harbour defence’, which was designed to encourage company directors to attempt to restructure companies that are at risk of insolvent trading, rather than simply placing the company into voluntary administration at the first sign of trouble; and
• were part of a broader set of legislative changes that were designed to encourage a ‘turnaround culture’ in Australian companies by removing some of the barriers to restructuring faced by struggling companies and their directors.

This article sets out the prohibition on insolvent trading by company directors in section 588G of the Act, reviews the safe harbour defence, including how it operates and when it does and does not apply, and provides a summary of the issues facing a director who is considering relying on the defence.

The prohibition on insolvent trading: section 588G of the Act

Section 588G of the Act imposes a positive duty on company directors to avoid insolvent trading.  Essentially, clauses 588G(1) and 588G(2) of the Act provide that a director will be in breach of the Act if they fail to prevent the company from incurring a debt where:

1. the company is insolvent, or, as a result of incurring that debt, becomes insolvent;
2. at the time when the debt is incurred, there are reasonable grounds for suspecting that the company is or will become insolvent; and
3. either:
   • the director is aware that there are grounds for suspecting that the company is or will become insolvent; or
   • a reasonable person in a like position in a company in the company’s circumstances would be so aware.

The ‘safe harbour’ defence: section 588GA of the Act

Section 558GA(1) of the Act sets out the safe harbour defence. This section states that the duty in section 588G(2) does not apply to a director and a debt if both of the following conditions apply:

1. at a particular time after the director starts to suspect the company may become or be insolvent, the person starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator; and
2. the debt is incurred directly or indirectly in connection with any such course of action during the period that starts at that time, and ends on the earliest of the following times:
   • the end of ‘reasonable period’ after the time that the course of action is determined, if the director does not begin to take the course of action in that time. The Act does not provide any further guidance on what would constitute a ‘reasonable time’;
   • when the director ceases to take the course of action;
   • when the course of action ceases to be reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator; and
   • the appointment of an administrator or liquidator of the company.

When a course of action will be considered to be reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator is not clearly specified in the Act.  Section 588GA(2) of the Act does, however include a non-exhaustive list of matters that may be taken into account in this regard, including whether the director has properly informed themselves of the company’s financial position, whether appropriate steps have been taken to prevent misconduct of company employees or other conduct that may affect the company’s ability to pay its debts, and whether the director is obtaining appropriate advice from an entity that is qualified to and has sufficient information to provide that advice.

The burden of establishing the defence: section 588GA(3) of the Act

Pursuant to section 588GA(3) of the Act, the director bears the onus of proving the existence of the safe harbour defence.

When the defence is unavailable: sections 588GA(4) and 588GA(5) of the Act

The safe harbour defence is, on the whole, limited to directors who are fulfilling their directors’ duties and ensuring that their company likewise complies with its legal obligations.

There are significant exceptions to the defence and to the evidence that a director can produce in support of its claim that the defence applies, which are contained in sections 588GA and 588GB of the Act.

Sections 588GA(4) and 588GA(5) of the Act state that the safe harbour defence is unavailable with respect to debts incurred in the following circumstances:

1. where the company is not substantially complying with its obligations to pay the entitlements of its employees as they fall due or to give returns, notices, statements, applications or other documents as required by taxation laws, or has failed twice or more to comply with such obligations within the 12-month period ending when the debt was incurred; and
2. where, after the debt is incurred, the director fails to comply with any of the following obligations in relation to the company, and that failure constitutes less than substantial compliance with that obligation:
   • the requirement to provide a controller of the company’s property with a report about the affairs of the company as at the control day;
   • where an order is made to wind up the company, the requirement to provide a liquidator with a report as to the affairs of the company as at the date of the winding up order or as at an earlier date specified by the liquidator;
   • where the company voluntarily resolves to appoint an liquidator, the requirement to give the liquidator a report about the company’s business, property, affairs and financial circumstances; and
   • where a company is ordered or resolved to be wound up, the requirements to:
     • deliver the company books to the liquidator;
     • attend meetings with the liquidator and/or the company’s creditors or members, and provide such information about the company’s affairs, as the liquidator reasonably requires;
     • do whatever the liquidator reasonably requires to help in the winding up;
     • do whatever a provisional liquidator reasonably requires to help them to exercise their functions and powers; and
     • to provide and update personal address and business address details with the liquidator, if required by the liquidator.

Pursuant to section 588GA(6) of the Act, a court can make an order that the exceptions in sub-sections (4) and (5) do not apply, but only where the court is satisfied that the failure of the director to comply with the relevant obligation arose due to exceptional circumstances or where it is in the interests of justice to make the order.

Pursuant to section 588GB of the Act, a director cannot rely upon books or information of the company as evidence that the safe harbour defence applies if the director has failed to permit the inspection of, to deliver, or to give those books or information in accordance with the requirements of the Act, or where a Court has issued a warrant pursuant to section 530C(2) of the Act because it is satisfied that a person has concealed, destroyed or removed books of the company or is about to do so.

Consequences of the safe harbour defence

One year on from these changes, it remains unclear whether the safe harbour provisions will lead to a significant change in the turnaround culture in Australia, for the following reasons:

1. the onus of proving that the elements of the defence are established falls on the director. Depending on the circumstances, this could be difficult for the director to prove;
2. whether or not a course of action is reasonably likely to result in a better outcome for the company than the immediate appointment of an administrator or liquidator and, accordingly, whether the defence is available, can change over time. The defence can be lost if a director does not immediately develop and implement a new course of action in response to changing circumstances;
3. a director will never be in breach of section 588G if they appoint an administrator or liquidator where the company is at risk of insolvent trading, but a director continues to be at risk of breaching section 588G if they attempt to rely on the safe harbour defence; and
4. a director will only know for certain whether the safe harbour defence applies if this is tested in a court.

Given these factors, many directors may prefer to continue to appoint an administrator where there is a risk of insolvent trading.  This is not to say that the safe harbour defence cannot be relied upon. It can, but care needs to be taken in executing such action to ensure compliance with the Act.

Section 588HA also provides that the government must undertake a review of the safe harbour provisions as soon as practicable after 19 September 2019.  It remains to be seen whether the safe harbour defence will be changed following the review that will take place in just under 12 months’ time.

At Bryks Lawyers, we have extensive experience in corporate law and can advise you on your role and responsibilities as a director.  Start the conversation today!.