A company is like a ship, with the directors taking the helm and navigating through hopefully always placid waters. But journeys are not always smooth sailing, storms do happen, and, in some instances, directors must act quickly to prevent the ship from sinking. This is the essence of the “safe harbour” rules – to protect directors from liability while they are trying to save a company from collapsing.
Australia has one of the strictest insolvent trading laws in the world, designed to protect creditors by imposing penalties against directors who allow a company to trade even when it unable to pay debts as they become due. New safe harbour rules passed in 2017 give directors a wider leeway in coming up with alternative solutions that might affect creditors’ recovery from insolvent companies.
When the directors see that the company is no longer able to pay its debts as soon as they become due, they must stop the company from incurring more debts. If the directors allow the company to trade even when they know that it is insolvent, they can face criminal or civil penalties, and can also be personally liable for insolvent trading.
“Safe harbour” is a defence for directors against their statutory duty to prevent an insolvent company from trading. The safe harbour starts to apply from the time directors, after suspecting that the company may become insolvent, start developing a course of action that could lead to a better outcome for the company. A better outcome generally means an outcome aside from the appointment of an administrator or liquidator, because this is a traditional solution to insolvency. The new safe harbour rules protect the directors so that they can come up with a restructuring plan that hopefully provides a higher payout for investors and creditors.
Issues on Voidable Preferences
An article from The Australian Financial Review, however, criticised the new rules as running against Australia’s insolvency policy of regulating the trading of insolvent companies. Under the new rules, directors can negotiate payment terms with creditors as long as they fully disclose the company’s financial situation, which according to KPMG is giving insolvent companies “licence to trade while insolvent as long as inside the harbour.”
AFR also pointed out a contradiction between the new safe harbour rules and voidable preferences. While directors are allowed to trade on their insolvent company and get away scot free, courts can claw back payments from creditors under the voidable preference rules. The rationale behind the claw back is equitable treatment of creditors such that all creditors should get their fair share from the insolvent company.
AFR also thinks the voidable preference rules are unfair to creditors who have a good credit control system and who are willing to negotiate with the directors of a financially troubled company. The new safe harbour rules seem to envision a scenario where there is one debtor and one creditor, but the reality is that there are multiple creditors, and creditors have their own creditors, and ad infinitum.
If the directors’ rescue plan does not work out, the new rules do not impose liability upon them because they were trying to save the company while under the protection of the harbour. In the end, if the company collapses and is sent to liquidation, creditors who negotiated with the directors will be left with nothing because the payments will be clawed back and returned to the estate to be equitably distributed to all of the debtor’s creditors.
While it may look like there is a dilemma in giving directors protection to create solutions for their troubled companies, maintaining a good debt management plan remains advantageous for creditors. On the side of companies and directors, acting immediately at the earliest sign of financial distress is the best way to achieve a better outcome for the company. Laws against insolvent trading punishes those directors who are trying to cheat on the system, while the new safe harbour rules protect the many other directors who have the genuine desire to preserve the company’s business, its relations, as well as their personal wealth.