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Suggested (temporary) changes to the insolvent trading regime

by Stephen on April 1st, 2020


In my view, New Zealand must follow a recent initiative (22 March) by the Australian legislature and introduce temporary measure to soften the impact of the restrictions on insolvent trading in the Companies Act 1993.  That Australian initiative has now been followed (at the end of last week) by an announcement that the wrongful trading provisions in the UK companies regime will be temporarily suspended so that business can continue without the threat of personal liability to directors.

To date, we have seen responses by New Zealand’s commercial regulatory authorities to the practical impacts of COVID-19 on the economy, including those by the FMA, NZX the Takeovers Panel and the Commerce Commission. 

These measures need to be supplemented by additional relief for companies and their directors, particularly those grappling with an unprecedented change to their business conditions and who need time to consider the company’s position while developing a turnaround plan.

The objective of such temporary relief is to manage the fear of exposure to personal liability for insolvent trading – and provide some clarity that will enable directors to investigate and implement restructuring proposals to turn businesses around, keeping the company alive.  In turn, this led to the destruction of value and job losses.  By contrast, the creation of a safe harbour would allow directors to keep the company “alive” while obtaining advice about restructuring options from professional advisers.

Key points

An urgent (temporary) amendment should be made to the Companies Act 1993 to provide a temporary safe harbour to enable company directors greater latitude to make decisions to continue to trade (and incur debts) in the ordinary/normal course of business, without the risk of personal liability.

Like Australia, the lifespan of this temporary relief should be 6 months – although, like its Australian counterpart, there should be scope for it to continue to operate for a longer (but still temporary) period.

The purpose of the temporary relief is solely to provide better scope for directors to take steps (including by continuing to trade and incur debts) where it is necessary, on the basis of a strategy and plan, to enable the business to continue.  This temporary relief is aimed at decisions which may include implementing a restructuring plan – as a result of the impact of COVID-19 (including the impact of the current lockdown and a post-lockdown recovery path).

In addition, I suggest that New Zealand follows the path taken in Australia to make it clear that, in the context of the temporary safe harbour, that ordinary/normal course of business is widened to include debts incurred in good faith with the aim of keeping the business going even if those debts are not ordinary/normal. 

Finally, as well as providing temporary relief only, I suggest that such a safe harbour for directors should be accompanied by similar checks and balances to those provided in Australia, including:

  • by imposing a positive burden of proof on those directors who seek to rely on the temporary safe harbour (to show good reasons for incurring the debt); and
  • including measures to ensure that directors do the necessary planning, take advice and keep a timely and accurate record of the state of the company’s business – including its compliance with other obligations such as those to employees.

Australian relief measures

The Australian relief measures are more complete and, I believe, more relevant to New Zealand. 

On 22 March, the Australian Government announced a range of temporary measures for financially distressed businesses.  A handful of those measures were designed to soften the blow of the predicted raft of insolvency proceedings (by lengthening timelines and increasing the financial thresholds for stating those proceedings). 

Whilst those measures are significant, I believe that the most significant is a 6-month temporary safe harbour effectively relieving directors from their duty to prevent insolvent trading with respect to any debts incurred in the ordinary course of the company’s business.  In effect, unless there is some “egregious dishonesty or fraud”, directors may avoid personal liability for insolvent trading.  (And there is a corresponding temporary safe harbour for holding companies for liability for insolvent trading by subsidiaries).

There are some existing points of difference between the Australian insolvent trading regime and that provided by sections 135 and 136 of the Companies Act.  Whilst the Australian provisions are labelled as ‘harsh’, they also include:

  • four hard-wired (legislated) defences for directors – which are not available in criminal proceedings based on dishonesty; and
  • since September 2017 – a safe harbour for directors to protect them from personal liability for debts incurred by an insolvent company if, after a director “starts to suspect” that the company may become or is insolvent, the director starts developing a course of action that is “reasonably likely to lead to a better outcome” for the company (i.e. better than liquidation).  Note that:  In order for the safe harbour to apply, the debt incurred by the company needs to be “directly or indirectly” in connection with that course of action taken by the director.

The policy for the introduction of the 2017 safe harbour was to provide a counterbalance – because the potential exposure of directors to personal liability was seen to be causing directors to act conservatively, resigning or (prematurely) putting companies into liquidation. 

Why temporary relief?

It is apparent that the Australian legislature intended that the temporary safe harbour would be applied to these extraordinary times.  (Otherwise the temporary safe harbour would be useless – because a debt incurred when the company is otherwise insolvent could not be said to have been incurred in the ordinary course of business).

The Explanatory Memorandum accompanying the introduction of the amendment provides some guidance by referring to examples – such as loans to restructure (by moving the business online or to pay employees during COVID-19.

Clearly, the temporary safe harbour is intended to have a wide application, and cover:

  • not only those debts incurred as part of the ordinary/normal course of business (i.e. day-to-day operations – such as incurring debts to trade creditors and employee expenses); but also
  • debts incurred for restructuring purposes to revamp the business – as well as the ‘new normal’ after the present lockdown has ended.

As well as providing temporary relief only, the Australian temporary safe harbour contains a number of checks and balances, including:

  • imposing a positive burden of proof on those directors who seek to rely on the temporary safe harbour (to show good reasons for incurring the debt); and
  • including measures to ensure that they do the necessary planning, take advice and keep a timely and accurate record of the state of the company’s business – including its compliance with other obligations such as those to employees.

It is also clear that the Australian temporary safe harbour does not remove the need for company directors to comply with their existing directors’ duties.  Therefore, in an environment where it may become increasingly difficult to point to debts as having been incurred in the ordinary/normal course of business because (during the 6-month period) it is clear that the company is facing more difficult times / reduced certainty that it will be able to pay its debts – there will be a need for the directors to ensure that the company has a recovery plan which extend beyond the next 6 months.

Put simply, directors must be able to point to a continuing / viable business at least by the end of the 6-month safe harbour (and possible even before that date – with these issues being quite fact-specific). 

Just as continuing to trade a financially distressed company without a clear plan for recovery would not have been tenable before the introduction of this temporary safe harbour – even after its introduction, it will be important that the directors make themselves aware of this temporary safe harbour, assess the company’s financial position in a proactive manner and take advice. 

Further clarification is expected to be provided as to the operation of the Australian temporary safe harbour by means of regulations.  It appears that these regulations will take the form of ‘negative assurance’.   This is not an approach that has been used in the New Zealand company law framework (although it is used in securities law under the Financial Markets Conduct Act 2013).  Given that regulators are dealing with an evolving situation – I suggest that it is something which should be considered in this case).

Temporary safe harbour extends to holding companies

The new Australian measures also extend to providing that a holding company may rely on the temporary safe harbour for insolvent trading by its subsidiary if it takes reasonable steps to ensure the temporary safe harbour applies to each of the directors of the subsidiary, and to the debt.  Again, the holding company bears an evidential burden in relation to these matters.

Here, some caution is required when making comparisons with Australian law.  In Australia, a holding company may be liable for the debts of a subsidiary if 5 specific criteria are met.  And there are both limits on the loss or damage that may be claimed and defences available for the holding company.

By contrast, in New Zealand, there is no direct right of recovery against a holding company for debts of a subsidiary.  Instead, section 271 of the Companies Act creates a unique mechanism for the pooling of assets of related companies where it is just and equitable to do so.  Only relatively recently (Lewis Holdings Ltd v Steel & Tube Holdings Ltd (2014)) have the New Zealand Courts provided much-needed clarity that section 271 allows the Court to order the parent of a company in liquidation to pay to the liquidators the whole or a part of all or any claims made against the subsidiary. 

I suggest that the types of measures that may be needed to plan for and implement a recovery strategy as a result of the impact of COVID-19 point to the need for similar (temporary) relief on this side of the Tasman, in a holding company / subsidiary context.  This, I suggest, would be a “for the avoidance of doubt” measure.

Suggested next steps for New Zealand

While I was researching these issues, I became aware that there is a proposed private member’s bill in the ballot (since 9 January) that seeks to add a permanent safe harbour to the Companies Act for insolvent trading – along the lines of the September 2017 Australian measure.  Whilst I have only looked at the drafting of the proposed private member’s bill briefly, my view is that any such permanent change should not be considered at this stage and should, instead, be the subject of the usual considered law-making process – which includes the scope for public consultation and submissions.

Instead, I suggest that the needs of the Level 4 lockdown and, particularly, a post-lockdown economic climate point to the need for New Zealand to follow the example provided by Australia – and provide temporary relief for company directors. 

Further information

If you would like more information about any of the matters discussed in this note, please contact me.

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