Is the threat of voluntary administration credible in restructurings?

By Timothy Sackar and Jillian Robertson

To mitigate their risk of personal liability, directors of companies in financial distress must properly engage with stakeholders to identify an appropriate course of action for the company to take in order to obtain the best economic outcome for the company and its stakeholders.

It is inevitable that companies will face periods of financial distress during their corporate lives. During these times, it is incumbent on the directors and management to seek to maximise the company's chances of survival and preserve value for stakeholders. Certainly it has not been uncommon for directors to use the threat of voluntary administration as a part of their stakeholder management strategy during these times. However, while liability for insolvent trading is very real and cannot be ignored, directors would be advised not to retreat without diligently exploring other viable options – or they may face liability for failing to act in the best interests of the company, which, in times of financial distress, includes taking into account the interests of creditors.^[1] This obligation is particularly pertinent for directors given the recent implementation of the safe harbour law reforms.

The decision to appoint administrators, instead of trading on while negotiating workarounds with stakeholders, will not always be in the best interests of the company and its creditors – and if this course is pursued by directors as a substitute for other available and less value destructive means, may be in breach of those directors' duties.

Parts 5.3A and 5.7B: harmonious or competing regimes?

Parts 5.3A and 5.7B were introduced into the Corporations Act 2001 (Cth) (the Act) over 25 years ago. Evidently, the legislature intended the voluntary administration and insolvent trading regimes to operate together.

The object of Part 5.3A is to provide for the business, property and affairs of an insolvent company to be administered in a way that maximises the chances of the company continuing in existence, or if it is not possible for the company or its business to continue in existence, results in a better return for the company's creditors and members than would result from an immediate winding up of the company.^[2]

The object of Part 5.7B is to provide for the recovery of property or compensation for creditors of an insolvent company. Relevantly, Division 3 of Part 5.7B imposes a duty on directors to prevent insolvent trading. Australia has been considered to have some of the most stringent insolvent trading laws of its Western comparators – directors will be personally liable if the company incurs a debt and there are reasonable grounds for merely suspecting insolvency.^[3] As such, it is perhaps unsurprising that directors find themselves in a position of conflict when their company is in the red.

Notwithstanding the legislature's intention that these regimes operate in unison, directors of companies in financial distress have previously been in a position of conflict between their desire to mitigate their risk of personal liability for insolvent trading (by immediately resolving to appoint an administrator – notwithstanding that a company may be viable in the longer term) versus their obligation to act in the interests of the company and its creditors.

The dance that directors must do at this critical time is delicate and should be continuously reviewed and critiqued. The fiduciary duty of a director to act bona fide in the best interests of the company requires a director not to have the company ignore or attempt to defeat its obligation to creditors^[4] – and the fiduciary relationship between director and company is such that if a director fails to perform his or her duties, equity will treat that breach as a breach of a fiduciary duty.^[5] This common law duty has developed out of a recognition that when a company is in financial distress, any action taken by the directors will be at the risk of the creditors (rather than the shareholders) because there will be little or no equity value in the company.^[6] In this regard, directors must bear in mind the path that will best serve the majority of stakeholders' interests.

Safe harbour: an extension of directors' fiduciary duties?

Amongst other things, the introduction of safe harbour^[7] has sought to mitigate directors' competing interests under Parts 5.3A and 5.7B of the Act. Section 588GA provides a carve-out for directors from insolvent trading liability if the directors are "taking a course of action reasonably likely to lead to a better outcome for the company".

While it is still early to predict how the Courts will apply this section (and indeed how they will interpret "reasonably likely to lead to a better outcome"), the legislature has stated that the intention of the law reform is to drive cultural change amongst directors by encouraging them to keep control of their company and take reasonable risks to facilitate the company's recovery instead of simply placing it prematurely into voluntary administration or liquidation.^[8] One can interpret the reform as an acknowledgment by the legislature that Parts 5.3A and 5.7B have not been operating as harmoniously as was intended. Indeed, the discord between the Part 5.3A and 5.7B regimes has not gone unnoticed by the Australian Courts.^[9]

Given this was the intention behind the law reform and the resulting safe harbour protection afforded to directors, the bar is higher than ever for directors to satisfy the proper purpose test under Part 5.3A (discussed below) if the board resolves to appoint administrators without properly engaging with stakeholders and investigating solvent workarounds.

Directors must now consider whether their fiduciary duty to act in the best interests of the company requires a course of conduct to be taken in reliance on the safe harbour provisions. In this regard, directors need to consider to what extent they need to act (including by consulting with stakeholders and seeking to implement any viable proposals put to the company by its stakeholders) to satisfy their obligations before throwing in the towel and appointing administrators.

Given the ongoing development of the law in this area, particularly the common law duty not to prejudice the interests of creditors when a company is in the red, directors now face the very real possibility that an appointment under section 436A may not satisfy the proper purpose test if the board has not consulted with key stakeholders and sought to achieve a solvent solution, if this course may be in the best interests of the company and its creditors.

Section 436A: safe harbour – a change to the proper purpose test?

The Part 5.3A legislative regime does not (nor has it ever) obligated directors to appoint an administrator. Section 436A of the Act provides that the company "may" appoint an administrator if the board has resolved that, in the opinion of the directors, the company is insolvent, or likely to become insolvent at some future time and that an administrator should be appointed. Of course, if in the directors' view the appointment of an administrator is in the best interests of the company and its creditors and achieves the object of Part 5.3A, then the directors should resolve to appoint an administrator and, save for any collateral purpose or ulterior motive on the part of the directors^[10], such an appointment would constitute a "proper purpose" under the Act.^[11]

Resolving to appoint an administrator for safe harbour is not a proper purpose under the Act. A director's duty to prevent insolvent trading does not override his or her duties to the company. If a director improperly resolves to appoint an administrator, he or she may still be personally liable to compensate the company for damages^[12] – as such, insolvent trading liability is certainly not the only risk directors need to be mindful of when trading during a period of financial distress.

In determining the validity of an appointment under section 436A of the Act, the Courts will consider whether, at the relevant date, the directors genuinely believed that the company was insolvent, or was likely to become insolvent, and whether that belief was reasonable in the circumstances. It is insufficient for the directors to have merely formed an opinion that the company's solvency is questionable.^[13] In the recent decision of Blackadder v McQuinn,^[14] the director of a company was criticised by the Court for not giving any "real thought" to whether the company was insolvent or was likely to become insolvent at some future time before passing a resolution under section 436A. In that case, the Court held that the director's actions were not taken in the best interests of the company as a whole and that the appointment did not attain the objectives set out in section 435A.^[15]The Supreme Court of New South Wales has also confirmed that the power under section 436A may only be exercised in the interests of the company as a whole.^[16]

Given the ongoing development of the law in this area, particularly the common law duty not to prejudice the interests of creditors when a company is in the red, directors now face the very real possibility that an appointment under section 436A may not satisfy the proper purpose test if the board has not consulted with key stakeholders and sought to achieve a solvent solution, if this course may be in the best interests of the company and its creditors.

Formal appointment versus informal workaround: stakeholder engagement is critical

The object of Part 5.3A is to preserve companies and maximise value for stakeholders. Directors need to engage with financial creditors and other stakeholders to identify whether this object will be best served via alternative workaround strategies or a formal appointment. If the interests of a company are not best served by the appointment of an administrator then any such appointment, if challenged, may be found to be invalid. It may also result in personal liability for the directors for breach of their duties to act for a proper purpose and in the best interests of the company and its creditors. The legislature and judiciary have made this clear.

To mitigate their risk of personal liability, directors must properly engage with stakeholders to identify an appropriate course of action for the company to take in order to obtain the best economic outcome for the company and its stakeholders. The legislature has acknowledged that the appointment of an administrator to a company is value destructive and increases the likelihood of the company being wound up.^[17] Accordingly, if there are options available to a company outside of a formal appointment that will maximise the chances of the company continuing in existence and provide a better economic return to creditors and other stakeholders, the directors must consider that alternative course.

This article was first published in the Insolvency Law Bulletin, May 2019.

Introduction

The Insolvency Practice Schedule: navigating creditors' new powers

^[1] Pearce v Gulmohar Pty Ltd [2017] FCA 660 at [461]-[464] (Rangiah J) citing Walker v Wimborne (1976) 137 CLR 1 at 7 (Mason J) and Bell Group Ltd (in liquidation) v Westpac Banking Corp (No 9) (2008) 39 WAR 1 at [4418] (Owen J).^{Back to article}^[2] Corporation Act 2001 (Cth), section 435A.^{Back to article}^[3] Ibid section 588G(1)(c). See for example, SX Projects Pty Ltd (in liquidation) v V Battaglia & Ors [2018] NSWSC 1830 at [34]-[36] (Black J).^{Back to article}^[4] Westpac Banking Corporation v The Bell Group Ltd (in liquidation) (No 3) (2012) 44 WAR 1, 140 [767] (Lee AJA).^{Back to article}^[5] Ibid [921] (Lee AJA).^{Back to article}^[6] Kalls Enterprises Pty Ltd (In Liquidation) v Baloglow (2007) 63 ACSR 557; Kinsela v Russell Kinsela Pty Ltd (In Liquidation) (1986) 4 NSWLR 722, 730.^{Back to article}^[7] Corporations Act 2001 (Cth), section 588GA.^{Back to article}^[8] Explanatory Memorandum, Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 (Amendment Bill). This statement refers to the both the safe harbour and ipso facto law reforms implemented by the Amendment Bill.^{Back to article}^[9] Edwards v Attorney General (2004) 60 NSWLR 667, 694, [154] (Young CJ).^{Back to article}^[10]Re Sales Express Pty Ltd (Administrator Appointed) [2014] NSWSC 460.^{Back to article}^[11] Directors owe a duty to exercise their powers and discharge their duties in good faith in the best interests of the company and for a proper purpose: Corporations Act 2001 (Cth), section 181.^{Back to article}^[12] Corporations Act 2001 (Cth), sections 1317E(1) and 1317H.^{Back to article}^[13] Kazar v Duus [1998] FCA 1378; (1998) 29 ACSR 321, 333 (Merkel J).^{Back to article}^[14] Blackadder v McQuinn [2017] NTSC 29.^{Back to article}^[15] Ibid 51 [114].^{Back to article}^[16] Re Condor Blanco Mines Ltd [2016] NSWSC 1196, [113].^{Back to article}^[17] Amendment Bill at [1.9].^{Back to article}