Member Article

The government has released a discussion paper outlining proposals for the reform of Australia's insolvent trading laws designed to ensure that the insolvency laws complement and assist the conduct of workouts. The paper seeks submissions on issues that arise for directors from operation of the insolvent trading laws, particularly in the context of attempts at business rescue outside formal insolvency administrations.

While the insolvent trading laws perform the public function of contributing to, maintaining and fostering ethical commercial behaviour and standards, there are unresolved arguments as to whether they may also have a negative impact by reducing the willingness of directors to engage in entrepreneurial and risk-taking activity designed to save a company. The laws, which induce directors to place companies into external administration to prevent insolvent trading, affect their ability to reorganize and rescue the company. Rather than a rescue or workout, the company may be placed into external administration by directors who are fearful of breaching the duty to prevent insolvent trading, which can render them personally liable for the compensation of creditors for losses suffered as a result of the insolvency.

A workout provides directors with the ability to continue business as usual under the control of existing management as an effective way to maintain value. Workouts are inherently flexible and cost effective where there is no formal appointment of an insolvency practitioner. However, at present, the insolvent trading laws continue to apply during any workout attempt and may constrain the willingness of directors to pursue a workout solution, unless they can be sure that the company will remain solvent throughout the workout period.

It is in this context that the government has raised for consideration two options for the future reform of Australia's insolvent trading laws: (i) the introduction of a business judgement rule for insolvent trading during a bona fide workout; and (ii) the introduction of an option for companies to invoke publicly a moratorium during which they may trade while insolvent.

Modified business judgement rule

The Corporations Act provides for a business judgement rule in relation to a director's duty to act with reasonable care and diligence. The rule deems a director to have acted in accordance with the obligations of care and diligence if certain criteria are met, including that the director is properly informed in relation to the relevant subject matter and rationally believes that the judgement is in the corporation's best interests.

The discussion paper proposes the introduction of a modified business judgement rule in relation to insolvent trading. The modified rule will introduce a provision to relieve directors of liability for breach of their duty to prevent the company from trading while insolvent if all the following criteria are met:

• The financial accounts and records of the company presented a true and fair picture of the company's financial circumstances at the time that the rule was invoked;
  
• The director received restructuring advice from an appropriately experienced and qualified professional with access to the company's accounts and records on the feasibility and means of ensuring that the company remained solvent, or that it would be returned to a state of solvency within a reasonable timeframe;
  
• It was the director's business judgement that the interests of the company's body of creditors as a whole, as well as members, were best served by pursuing restructuring; and
  
• The restructuring was diligently pursued by the director.

Insolvent trading moratorium

Invoking a moratorium would allow a company a specified timeframe within which insolvent trading laws would not apply. Such a moratorium would be expressly and openly invoked, but would not apply to dishonest insolvent trading.

In order for the moratorium to be invoked, a threshold test is proposed. The sample threshold test is that a director must rationally believe that the company is insolvent or in imminent danger of becoming insolvent, and also believe that it is in the creditors' interests as a whole that an attempt to reorganize the company's affairs be made outside an external administration.

Under the moratorium, the company would be required to inform the market and creditors of its insolvency and its plans to reorganize its financial affairs outside an external administration. This would give new creditors adequate knowledge of the company's financial status.

Existing creditors may be provided with rights to terminate the moratorium if they collectively consider insolvent trading to be against their best interests. This would be carried out at a creditors' meeting or by court order.

Creditors might also be given a role in determining whether a moratorium should be extended past the given timeframe. If this were the case, it is likely that the court would be given power to veto creditor dissent where a company could show that the moratorium would not substantially increase the risk of a creditor suffering a loss.

Maintenance of the status quo

The other option raised by the discussion paper is maintenance of the status quo and the implementation of no changes to the insolvent trading laws. This reflects the view that while the existing state of the law leads to costs arising from the effect of the insolvent trading laws on informal workouts, the potential consequences of a weakening of the prohibition against insolvent trading may warrant making no changes.

The government has called for submissions on the proposals by 2 March 2010.