The rapid change to business conditions as a result of the COVID-19 pandemic has seen a profound impact on the ability of many businesses to generate revenue. In a jurisdiction where a “cash flow” rather than a “balance sheet” test is the prevailing measure of a company’s solvency, the drying up of (or at least inability to reliably forecast) cashflow creates an environment in which many directors, acting reasonably, will entertain a suspicion that their company is unable to pay its debts when due. Under the insolvent trading laws, a director who permits a company to incur a debt in these circumstances risks being personally liable for that debt.
What is safe harbour?
Safe Harbour is a range of reforms brought about to encourage businesses in distress to restructure and survive, where that distress might otherwise have resulted in a formal insolvency appointment (administrators or liquidators). The “Safe Harbour” is the protection the Corporations Act gives directors from liability for “insolvent trading” – personal liability for debts incurred by a company where there is reason to suspect a company might be insolvent. The reforms give directors the flexibility to focus on developing and implementing a plan to return a viable business in distress to profitability. Holding companies (for example, a parent company holding 50% or more shares in a subsidiary) can also attract insolvent trading liability, and also have access to Safe Harbour.
Changes to the safe harbour regime
- The safe harbour regime was introduced to encourage honest directors to, although harbouring a suspicion of insolvency, continue to trade without the spectre of personal liability on the proviso that:
1. the company’s employee entitlements and tax lodgements are up to date; and
2. the directors are developing a course of action that is likely to lead to a better outcome for the company than an immediate administration or liquidation.
Under recent changes to the safe harbour laws brought about in response to COVID-19, for six months commencing on 24 March 2020 directors need no longer satisfy the second of the above criteria. Directors will instead enjoy safe harbour protection so long as debts are incurred “in the ordinary course of business”. Honest directors will have very little difficulty in satisfying the “ordinary course of business” test. First, the Explanatory Memorandum to the amending legislation suggests that the phrase “in the ordinary course of business” will be interpreted differently than the interpretation of that phrase courts have adopted in other contexts. The focus of the enquiry will be whether the debt is necessary to facilitate the continuation of the business. For example, taking a loan to move operations online and paying wages is permissible. Secondly, it is extremely unlikely that courts will, by adopting too technical an approach to the application of the test, punish directors in a COVID-19 environment who are acting honestly and trying to save their business.
Holding company liability
Insolvent trading liability applies to holding companies as well as directors. To access safe harbour, a holding company must be able to demonstrate that it took reasonable steps to ensure safe harbour applies in relation to each director. As a result of the recent changes, a holding company will be required to demonstrate that it took reasonable steps taken to ensure that each director incurred only those debts necessary to facilitate the continuation of the business. This may require a far greater degree of oversight than that which a holding company may have been accustomed to exercising pre-COVID-19.
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