An impending flood of formal insolvencies or a continued decline?
By Jennifer Ball and Alexandra McCulloch
Conventional wisdom says there will be a flood of insolvencies in a recession, but there are other forces at work.
Chapter image Formal insolvencies flood or drought?

The COVID-19 pandemic and the associated lock downs have led to a global economic slowdown, and Australia has been no exception. GDP fell by 0.3% in the March quarter, and on 3 June 2020 Treasurer Josh Frydenberg announced that Australia was officially in its first recession in 29 years.

While the Australian Government was quick to provide a range of economic support measures – having already spent $289bn or 14.6% of GDP in an attempt to keep the economy afloat – Treasury expects Australia's GDP will decline by 0.5% in 2019-20 and a further 2.5% in 2020-21.

Although some sectors of the economy will still experience growth, a number of industries will experience a continued decline in revenue throughout 2020-21 with the sharpest declines to hit international airlines, housing construction sector and pubs, bars and nightclubs.

So the question is "will there be a flood of formal insolvency appointments once the Government support measures are wound back in late September 2020?"

Conventional wisdom would say "yes" – after all, traditionally a recession leads to rising formal insolvency appointments – but so far this has not occurred. It would be reasonable to assume that Government measures to support the economy are the cause, but some figures from the Australian Securities and Investments Commission (ASIC) show a more complex picture.

Not only have formal insolvency appointments been decreasing over the last few years, they have actually decreased in 2020 compared to the same period in previous years, based on the number of companies entering external administration. A recent survey conducted by the Australian Restructuring, Insolvency and Turnaround Association (ARITA) supports that finding; according to it, 78% of insolvency firms have seen a decrease in their appointments compared to the same period last year.  

Image of Reduction in Appointments - voluntary admin Charts


In fact, according to ASIC, there has been a fall in the number of registered liquidators, and ARITA says close to 55% of insolvency firms are actually accessing Government assistance with 14% of firms reporting that they had implemented "a few" redundancies as a result of the downturn in work with another 10% expecting to.

So what is going on? And what does it mean for the long-term future of the insolvency sector and the regime under which it operates?

Government support measures keeping companies afloat

Without temporary COVID-19-related amendments, many otherwise profitable and viable businesses could have faced financial distress.

Insolvency regime

The first temporary amendment is the introduction of a new safe harbour in section 588GAAA. This new safe harbour "temporary relief due to coronavirus" provides directors with protection from personal liability for any debts incurred by a business while insolvent. This relief will only apply to debts incurred in the ordinary course of the company's business during the six-month period and directors must continue to comply with their other legal obligations for example, director's duties to act in good faith and in the best interests of the company. Notably, no prescribed statutory thresholds are required to be satisfied for directors seeking the protection from personal liability for debts incurred by a business while insolvent under section 588GAAA in comparison with that protection under the existing safe harbour in section 588GA, for example, having to ensure that all employee entitlements are paid and up to date including superannuation. The onus of establishing the protection of the new "temporary safe harbour" rests on the person seeking to rely upon the protection. The company will remain liable for all debts incurred.

An insolvent company who has continued to trade under the temporary protection in section 588GAAA could attempt to transition to the existing safe harbour protection in section 588GA of the Corporations Act. This could lead to two very different scenarios. Some companies may be able to utilise the temporary protection period to effectively implement the statutory safe harbour protection measures under section 588GA, to successfully restructure their businesses. Oddly, statistics indicate that there has been a decline in the levels of safe harbour advisory work. Other companies may simply do nothing, continue to trade while insolvent in breach of their general director's duties, with a potentially devastating impact on unsecured creditors and ultimately, employees.

Another temporary amendment that has led some businesses to continue trading is the changes to the statutory demand thresholds. The statutory minimum for the issuing of a statutory demand has increased from $2,000 to $20,000 and the period for compliance with a statutory demand, has been extended from 21 days, to six months. We predict that the Government will move to scale this temporary amendment back after 24 September 2020.

Employee support

The JobKeeper program has also assisted companies with managing any short-term cash flow issues by providing support for payment of employee wages. While the program was due to end on 27 September, it will now continue (albeit in a reduced form) until March 2021.

Credit and capital

The big four Australian banks have agreed to extend repayment deferrals by up to four more months, providing them with time to assess the financial condition of borrowers who have been affected by the pandemic and borrowers with time to consider any restructure and make appropriate arrangements. It also removes the risk of a "fiscal cliff" effect in the second half of 2020, which would otherwise see borrowers unable to resume repayments once the support is removed.

It is said that the extended deferral time will provide affected borrowers with time to improve their financial circumstances. However, the bank extensions are to be granted in a case by case basis where the banks will work with the borrower companies to ensure that they are able to resume payments by exploring options for example, converting to interest only and extension of loan terms. Importantly, although interest rates are low, interest is still being capitalised, leaving the amount of the debt owed at the end of the deferral period greater than what it otherwise would have been.

Is the safe harbour encouraging restructures instead of formal appointments?

The Explanatory Memorandum to the safe harbour stated that the reform was to encourage directors "to keep control of their company, engage early with possible insolvency and take reasonable steps to facilitate the company's recovery instead of simply placing the company prematurely into voluntary administration or liquidation".

Despite directors' best efforts, some companies will not be able to recover and will still proceed to voluntary administration or liquidation. Provided that the director was developing or pursuing a course of action reasonably more likely to lead to a better outcome for the company, then they will still have the benefit of safe harbour in these circumstances. If the safe harbour is being used and distressed companies are able to successfully restructure, then it follows that there should be a fall in the number of formal insolvency appointments.

While there has not yet been any empirical studies considering the safe harbour, a number of small reviews have occurred.

When one considers that the vast majority of companies that enter insolvency are small companies, this could be a significant issue. This is further heightened as the sectors of the economy which are most likely to be impacted by the economic effects of COVID-19, are predominately comprised of small and medium entities.

Further, in ARITA's mid-June survey it was found that the use of the safe harbour has actually declined since the pandemic began, with 31% of respondents saying that their safe harbour work was at lower levels and only 6% reporting any increase in safe harbour work.

Accordingly, while a recession may seem like the perfect time to test the effectiveness of the safe harbour it may be too early to extract any new trends, and the introduction of the emergency legislation in section 588GAAA may only complicate matters of permanent reform at this stage.

Survey-results ARITA image
McGrathNicol reviewed companies to which it was appointed as external administrators and found…
Survey-results ARITA image

Are voluntary administrations picking up the slack?

While the safe harbour can provide companies with protection from insolvent trading while completing a restructure, it is not the only option. Voluntary administration is also used as a tool in company restructures although in saying this, external administration can destroy a company's goodwill and value. Safe harbour offers directors an opportunity to restructure without the worry and personal liability of insolvent trading.

Even before the introduction of the safe harbour, Australia was experiencing a fall in the number of voluntary administrations.

Image of Companies entering into Administration - voluntary admin Charts

This decline is not necessarily unexpected as Australia has experienced a sustained period of economic growth, but voluntary administrations are often considered too expensive and ill suited to small and medium entities, which are the companies most likely to fail and to be impacted by COVID-19. Similar claims have also been made in relation to the use of schemes of arrangements and DOCAs by small and medium entities.

A flood, a trickle or a drought?

This decline coupled with the move away by the insolvency and restructuring market from the days when the banks appointed receivers and enforced their security position to pursue recoveries, has led to calls that there is a need for Australia to have a strong rescue and restructuring processes for viable businesses which encourages financially distressed companies to seek informal restructures by working together with their lenders. The UK has led the way on that front with its reforms which came into effect on 26 June 2020; they introduce new corporate restructuring tools and temporary easements to give distressed businesses the breathing space they need to get advice and seek a rescue.

There have been numerous calls for reform to the Australian insolvency regime, with the hope of creating a regime that is even more debtor friendly and thus encourages entrepreneurship and economic growth as oppose to stigmatising business failures. These have ranged from amending the unfair preference regime, streamlining the voluntary administration process to a fast track and cost effective process for SMEs, expanding the availability of DOCAs outside the formal administration process and improving the scheme of arrangement process. Most recently in July 2020, the Australian Small Business and Family Enterprise Ombudsman released its Insolvency Inquiry Report, which recommended a number of reforms targeted at small businesses including establishing a Small Business Viability Review Program, a Small Business Debt Hibernation Program and a Director's Insolvency Agreement. All three of these measures are intended to assist directors of small business to identify the best way to manage their business and assist in developing appropriate restructuring arrangements.

While reforms may arguably be more important following the COVID-19 pandemic it is not yet clear which, if any measures, may be adopted by the Government and the effects of the recession must be fully felt before it becomes clear what changes are needed.

That is because the new temporary safe harbour relief has encouraged many non-viable businesses that might otherwise have entered into a formal insolvency arrangement to continue trading.

Not only have these temporary amendments made it more difficult for creditors to commence a winding up application but they also act to prevent companies from entering into formal insolvency proceedings, as statutory demands can act as a prompt to companies to examine their financial viability.

But any prediction of a flood of insolvencies once the measures are removed must be tempered with the knowledge of Australia's notable decline in formal appointments and voluntary administrations. The key might lie in the seeming under-utilisation of the safe harbour regime. The temporary COVID-19 measures have created an important breathing space for companies in trouble. Whether they have taken advantage of it will soon be revealed.