From Red to Black - August 2017 - FromRedToBlack2017-2018

Introduction

Welcome to the third edition of From Red to Black in which we analyse key developments in the Australian restructuring market.

We were delighted to receive your feedback on our last edition, including that the publication was "concise, interesting, informative", provided a "really insightful perspective on Australian restructuring", contained "excellent insights" and (perhaps most importantly!) was "de-lawyered".

For 2017-2018 we have decided to deliver From Red to Black in smaller parcels periodically throughout the year. In this first instalment, we critically assess how our predictions in the last edition panned out, consider the implications of the recent decision of the Supreme Court of Western Australia in Hamersley v Forge (set-off and security interests in insolvency), in which our firm acted for the successful receivers, and report on the final form of the safe harbour and ipso facto reforms.

Please feel free to contact us if you would like to discuss any of these topics ‒ as always, it would be our pleasure to discuss these with you.

Predictions for FY17 — how did they pan out?

Commodities

Prediction: Commodities will recover and metal prices will continue to maintain strong pricing.

Commodities

Outcome: Correct. Australia's Chief Economist: "Australia’s resources and energy export earnings are forecast to reach an all-time high […] in 2016–17 and 2017–18." Read more

Commodities

Prediction:

A glimmer of hope exists in the commodities market. As we predicted, the downturn in the commodities cycle troughed in January 2016 (Cameron Belyea, Financier Worldwide). Most metal prices recovered in the six months ending in June 2016 and may be stabilising, though there will continue to be pricing shocks over coming months. For the balance of CY2016, precious metals and rare elements are likely to maintain strong pricing, while nickel and metallurgical coal has come back well over the past few months. This bodes well for revenue stabilisation across a range of mining enterprises. That said, the market has a long way to go to restore value ‒ Australian Bureau of Statistics data show the capital value of metal ore mining reduced in FY15 by 12.9% or $9b, related to falling commodity prices. The upturn seen since January 2016 has not fully restored value.

Outcome:

We nailed this one according to Australia's Chief Economist. In his March 2017 report he said "Australia’s resources and energy export earnings are forecast to reach an all-time high of $215 billion in 2016–17 and 2017–18. In real terms, this represents 32 per cent growth on 2015–16. Higher prices for iron ore and metallurgical coal, as well as increased LNG export volumes, are likely to be the most significant contributors to growth in export earnings"

Capital raisings

Prediction: We will see a new wave of capital raisings.

Capital raisings

Outcome: A mixed bag.

Read more

Capital raisings

Prediction:

We are also starting to see signs of a new wave of capital raisings as those across mining services, mining more generally and some industrials engage in balance sheet repairs ahead of any market uncertainties in FY17.

Outcome:

A mixed bag ‒ the successes of the market (eg NRW, MACA, AGC/Ausgroup) have been raising capital or dealing with bondholders, while others have been forced down expensive restructure and balance sheet repairs, mainly using schemes of arrangement (see Emeco, Bis Industries, Boart Longyear) or going private (Bradken). Many others raised capital in 2017, paid down debt or have sought to rebuild around more profitable, and smaller, contracts.

Security enforcement

Prediction: Heightened scrutiny will make security enforcement more difficult and restructuring options will remain a strong focus.

Security enforcement

Outcome: Maybe?
Most signs point to the continued preference for restructuring options.

Read more

Security enforcement

Prediction:

In the credit value industry, we expect heightened scrutiny will make security enforcement more difficult. Accordingly, we expect that restructuring options, where viable, will remain a strong focus, particularly in the current economic climate. In this respect, boards of impaired ASX entities will see Atlas Iron as a beacon for early engagement of turnaround advisers.

Outcome:

The financial sector continues to support customers undertaking realistic balance sheet and capital restructures. Retail politics aside, the banking sector has shown strong support for corporate entities, properly advised and following turnaround plans. With the safe harbour legislation likely to encourage directors to retain qualified restructuring advisers and work with stakeholders such as banks, and allowing for the continuing scrutiny of bank actions, there is no reason to believe restructuring options will not continue to be favoured by credit enhancement teams inside banks. Enforcement remains a last option, after exploring rehabilitation and debt trading options.

Security arrangements

Prediction: The Forge decision will impact on the way lenders structure their security arrangements, particularly in the construction sector.

Security arrangements

Outcome: The decision, at first instance, in favour of Forge will likely impact the way principals contract in the future.

Read more

Security arrangements

Prediction:

We expect the Forge decision (when handed down) will impact on the way lenders structure their security arrangements, particularly in the construction sector. The precise impact will depend on how the Court views the relative strengths and weaknesses of a PPSA security interest in an insolvency situation. For instance, if Hamersley is successful, this may prompt lenders to impose more costly and onerous security arrangements on borrowers, because of the risk that the lender could lose its security to a third party contractor through insolvency set-off. If the receivers succeed, principals will need to revisit how they guard against contractor insolvency risk, which may include higher upfront requirements from contractors, potentially making it more difficult to secure larger, higher value contracts.

Where rehabilitation is not possible, mainstream financiers are likely to move from a forbearance mindset to seeking to exit relationships with impaired creditors. Ignoring agribusiness, this will likely entail limited enforcements, favouring slightly discounted to par trades or refinancing from debtor raisings (capital or new offshore capital). Reporting and capital requirements (Basel III, APRA and increasing costs of offshore funding) will also impact on trends in this sector.

Outcome:

This decision was handed down earlier this year, with our client, the receivers and managers of Forge Group Power, succeeding at first instance, a decision which will likely impact the way principals contract in the future, having regard to the risk of being required to pay contractual claims to the insolvent contractor, with little or no prospect of any recovery of amounts owing from that company.

Brexit

Prediction: Brexit will create uncertainty and the UK may lose appeal to consumers.

Brexit

Outcome: Largely correct.
Business investment in the UK has been affected by Brexit uncertainty. There are calls for transitional arrangements. Read more

Brexit

Prediction:

The prospect of Brexit has sent shock waves globally and creates uncertainty in the market, particularly over when Brexit will happen. Prime Minister May recently announced that the United Kingdom will formally invoke Article 50 of the Lisbon Treaty to begin the two-year negotiations to exit the EU by the end of March 2017 and a "Great Repeal Bill" will soon be put to Parliament to avoid all European law.

When Brexit occurs, while its purely domestic insolvency laws will be unaffected, the UK will lose the benefit of the EU's uniform cross-border insolvency laws. Additionally, UK rulings under domestic law on receivership, schemes of arrangement and liquidation could lose the automatic recognition and enforceability in the EU that they currently enjoy. In the short term at least we expect to see an impact on the pricing of, and the appetite of purchasers for, distressed debt involving UK assets, and the UK may lose some of its appeal as the choice of contracting jurisdiction until stability and consumer confidence is restored.

Outcome:

Having invoked Article 50 of the Lisbon Treaty, the UK will cease to be a member of the EU on 29 March 2019. There remains a lack of clarity regarding the recently elected minority Conservative Government's Brexit strategy and whether it will push for a "hard" or "soft" Brexit in light of the Prime Minister's weakened position in the House of Commons. What is clear is that the government's stated aim of concluded negotiations within the two-year timeframe is hopelessly naive. The best that can be hoped for by March 2019 is an agreed framework and associated transitional arrangements. Cross-border insolvency issues are unlikely to be in even the top 50 topics the subject of the negotiations.

Safe harbour

Prediction: Safe Harbour reforms will not be part of Australia's law by the end of FY 2017.

Safe harbour

Outcome: Correct.
As at the end of FY 2017, Safe Harbour reforms are still not part of Australian law.

Read more

Safe harbour

Prediction:

While the Federal Government has allowed the industry an additional six months to implement many of the Insolvency Law Reform Act 2016 reforms, it is pressing on with the second tranche of reforms to enhance business rescue and support entrepreneurship as part of the National Innovation & Science Agenda. Nonetheless, our expectation is that the safe harbour reforms will not be part of Australia's law by the end of this financial year.

Outcome:

It is highly likely that the safe harbour reforms will be enacted in FY18 - see "Safe harbour for directors".

Key decision on the operation and limitations of set-off in insolvency: Hamersley v Forge

Last year, we were awaiting a key decision in the Supreme Court of Western Australia concerning the limitations of set-off in a liquidation scenario, and the nature and effect of a security interest under the Personal Property Securities Act 2009 (Cth) (PPSA).

We are now pleased to report that this decision was handed down earlier this year in Hamersley Iron Pty Ltd v Forge Group Power Pty Ltd (In Liquidation) (Receivers and Managers Appointed) [2017] WASC 152, with the receivers and managers of Forge succeeding at first instance. This decision will likely impact the way principals contract in the future, having regard to the risk of being required to pay contractual claims to the insolvent contractor, with little or no prospect of any recovery of amounts owing from that company.

Clayton Utz acted for Forge's receivers in the litigation, led by partners Alistair Fleming and Clive Luck, with Senior Associates Fiona Schmedje, Rebecca Hanrahan and Dougal West.

Seeking set-off and getting the court involved

In this case, Forge had entered into a number of contracts with Hamersley under which Forge would provide engineering, procurement and construction services to Hamersley in relation to a number of major mining projects in the north west of Western Australia. Forge had, in turn, charged its rights under the contracts (in particular, Forge's rights to receive payment from Hamersley) in favour of a secured creditor under a general security agreement, which was registered on the PPSR. When Forge subsequently went into voluntary administration and receivers were appointed, Hamersley terminated the contracts, leaving both parties with substantial claims against each other: Forge for unpaid moneys and Hamersley for damages.

The central question was one of set-off. Hamersley argued that its claims against Forge far exceeded Forge's claims against it, so it was entitled to set-off with the result being that it would not have to pay any money to Forge and could prove for the balance owing to it in Forge's liquidation. The Receivers disputed the net position would be in Hamersley's favour, but in any event argued that Hamersley had no entitlement to set-off in the circumstances.

Before undertaking the significant exercise of proving their monetary claims against each other, the parties agreed to seek guidance from the Court, by way of preliminary questions, to determine the set-off rights between them, as that could materially affect the claims which ultimately needed to be determined by the Court (for instance, if Hamersley had no right to set-off its claims against Forge, Hamersley's only avenue would be to prove as an ordinary unsecured creditor in Forge's liquidation, which could occur without involving the Court).

Hamersley's and the Receivers' arguments

Hamersley argued several entitlements to set-off including under the contracts themselves (the set-off rights within which it said were preserved by section 80 of the PPSA), section 553C of the Corporations Act 2001 (which provides for set-off in a liquidation scenario, between the company in liquidation and a party, where there is "mutuality" of credits, debts or dealings between those parties) and in equity.

The Receivers argued that the only avenue for set-off in liquidation was section 553C, which operated as an exclusive code, such that contractual and equitable set-off was no longer available. Further, that section 553C did not operate in favour of Hamersley in the circumstances, because there was no "mutuality" of interest between Forge and Hamersley as Forge had charged its rights and interests under the contracts in favour of the secured creditor.

Why this was contentious

Before the PPSA, there was judicial support for the position that a fixed security interest, could sever or destroy "mutuality" under section 553C where it had the effect of transferring or assigning the beneficial interest held by the company in liquidation in the charged property in favour of the secured creditor. This position had not been judicially considered since the PPSA came into effect in 2009, nor the nature, scope and effect of a PPSA "security interest", its effect on the interests between the parties, and whether concepts such as "fixed and floating" had any continuing relevance.

Pre-PPSA concepts are redundant, and other findings of the Court

The Court agreed with the Receivers and found that Hamersley was not entitled to set off the moneys it owed Forge against the moneys Forge owed it. In summary, the Court found that:

When a company is in liquidation, the only avenue to set-off debts as and between the company and its creditors is section 553C, which operates to the exclusion of equitable set-off and any form of contractual set-off.
Section 80 of the PPSA did not trump section 553C in a liquidation scenario, meaning that any contractual rights preserved under section 80 could not be relied on when section 553C applied.
The pre-PPSA concepts of fixed and floating (including crystallisation) are now redundant. A PPSA "security interest" is a statutory interest that is proprietary in nature, with its operation essentially fixed in nature but able to be modified by agreement. In this instance, the security interest remained fixed in relation to Forge's contractual rights to receive payment from Hamersley.
A PPSA "security interest" can upset the operation of section 553C, as the proprietary interest it creates in favour of the secured creditor has the effect of bringing to an end "mutuality" of interest between the set-off parties. This is because the proprietary interest removes the secured assets from the pool of assets available to the general body of creditors for the exclusive benefit of the secured creditor to satisfy the secured obligations.

As a result, Forge may now pursue Hamersley for all moneys owing to it under the contracts, for the benefit of the secured creditor. In contrast, Hamersley may only prove for any amounts owing to it under the contracts as an ordinary unsecured creditor in Forge's liquidation.

Key take-outs

This decision is significant for a number of reasons:

It renders contractual set-off clauses of no effect when a company goes into liquidation.
It confirms equitable set-off has no part to play when section 553C applies.
It potentially exposes counterparties to the risk of being required to pay moneys to a company in liquidation, in circumstances where they cannot set-off the moneys the company owes them, leaving that party with only a right to prove as an unsecured creditor in the liquidation, which may be worthless. Should the security be granted without the knowledge of the counterparty and in breach of the contract, the counterparty would likely only be left with a damages claim, which itself would be an unsecured claim against the company in liquidation.
It adds some further clarity to the interplay between the Corporations Act and the PPSA, suggesting that, in a liquidation scenario, the Corporations Act prevails.
It adds some clarity to the nature and scope of a PPSA 'security interest' which is a proprietary interest which is essentially rigid on attachment unless contractually relaxed by the parties.

Given the significant commercial consequences which can follow for parties dealing with contractor insolvency, the decision will likely impact the way principals contract in the future, having regard to the risk of being required to pay contractual claims to the insolvent contractor, with little or no prospect of any recovery of amounts owing from that company. For example, principals may increase security value requirements under bonds and bank guarantees, favour complex and regular netting arrangements through the term of the contract and insist on tripartite arrangements with financiers. Furthermore, it may see changes to security instruments, where the intention of the parties is for the security interest to operate more akin to the old concept of a floating charge, requiring the parties to specifically relax the operation of the rigid default PPSA security interest.

The decision has now been appealed to the Western Australian Court of Appeal and will likely be heard in 2018.

Safe harbour for directors

Australian directors face one of the harshest insolvent trading regimes in the world.

This fact has frequently been cited as an impediment to the successful restructuring of financially distressed businesses.

Another challenge for viable restructures is those contractual clauses which permit a party to unilaterally terminate the agreement if the other party becomes subject to formal insolvency proceedings (ipso facto clauses).

The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 tackles both those issues:

it creates a safe harbour so that directors will only be liable for debts incurred while the company was insolvent where it can be shown that they were not developing or taking a course of action that at the time was reasonably likely to lead to a better outcome for the company than proceeding to immediate administration or liquidation; and
it stays the enforcement of ipso facto clauses that are triggered by the appointment of a voluntary administrator, the appointment of a managing controller over all or substantially all of the company's property or where the company is undertaking a scheme of arrangement for the purpose of avoiding being wound up in insolvency.

While there are some uncertainties about how aspects of these reforms will operate in practice, the motivation behind them is to be applauded. In particular, the Australian economy will benefit from a culture which no longer stigmatises business failure but encourages honest and diligent directors to explore whether a failing business is capable of restructure.

Safe harbour reforms

It has long been said by some that, while the object of the voluntary administration regime in the Corporations Act 2001 (Cth) is to maximise the chances of survival of the business of an insolvent company, the appointment of an administrator is often made too early by directors who are more concerned about the risk of personal liability for insolvent trading than the survival of the business.

Premature appointment tends to be value-destructive, making it harder for a company in financial distress to restructure and continue to operate for the benefit of its employees, creditors and shareholders.

The Bill creates a safe harbour which operates as a carve-out from the civil insolvent trading provisions of the Corporations Act (not a defence).

It is intended to protect those directors who are acting honestly and diligently in attempting to restore the company to solvency. For that reason, safe harbour will not be available where the company has failed to comply with its statutory obligations to:

pay employee entitlements when due (including superannuation); and
meet taxation reporting obligations.

It will also not be available if the director fails to provide the administer/liquidator with certain required information.

Even if the safe harbour is available, it will not protect a director from actions brought for any other breach of the law including breach of director's duties.

Scope of safe harbour

To invoke the safe harbour protection, a director must:

ask him or herself whether the company may become or is insolvent; and
if so, take one or more courses of action within a reasonable time that is reasonably likely to lead to a better outcome for the company.

The protection will apply from the time the director starts developing the course of action, until:

the director fails to take any such course of action within a reasonable period; or
the course of action ends; or
the course of action stops being reasonably likely to lead to a better outcome for the company; or
the company goes into voluntary administration or liquidation.

If the director is entitled to rely on the safe harbour protection, it will apply only to those debts incurred directly or indirectly in connection with developing and taking the course of action.

There are a number of issues arising from the drafting of the Bill which we consider below and then outline some tips to enhance the prospect of a director being able to rely on the safe harbour protection.

Debts incurred "directly or indirectly in connection with" the course of action

In many restructurings it will not be crystal clear whether particular debts which are being incurred are sufficiently connected with the restructuring initiative. For example, will debts incurred in the ordinary course of business of the company be indirectly in connection with its restructure?

Reasonably likely to lead to a better outcome

Reasonably likely requires a chance of achieving a better outcome that is not fanciful or remote but fair, sufficient or worth noting.

A better outcome is one where the company is better off compared to the immediate appointment of an administrator or liquidator to it. This may not be a straight forward analysis, especially when decisions are being made by a director under time pressure with imperfect information.

The Bill provides (as a guide only) a non-exhaustive list of factors to be considered when determining whether a course of action was reasonably likely to lead to a better outcome for the company at the time it was taken. Those factors include whether the director has:

taken steps to prevent misconduct by officers and employees of the company;
taken steps to ensure the company is keeping appropriate financial records consistent with the size and nature of the company;
obtained advice from an appropriately qualified entity;
properly informed him or herself of the company's financial position;
taken steps to develop or implement a plan for restructuring the company to improve its financial position.

Appropriately qualified entity

The Bill does not define appropriately qualified entity.

This flexibility allows for the circumstances which apply to a particular company to frame the nature of advice required. A small business might only need an accountant or lawyer. A larger enterprise may require advice from a broad range of advisers, including restructuring lawyers and practitioners, specialists who have experience in dealing with operational turnaround issues, tax experts and so on. Each such advisor will need to have appropriate educational qualifications, experience, membership of a professional association and standing.

Safe harbour for holding companies

The safe harbour protection will be available to a holding company when the directors of the subsidiary company have the benefit of the safe harbour, and the holding company has taken reasonable steps to ensure the directors of the subsidiary have the benefit of safe harbour.

Tips

If a director suspects the company may become or is insolvent, the director cannot afford to take a passive approach.
The director must engage early with the risk of potential insolvency and seek appropriate advice.
The director will need to ensure that the company is paying employee entitlements and meeting its taxation reporting obligations.
The director should ensure that the course of action (the turnaround plan) addresses operational, strategic and financial issues and the steps required to implement the plan.
The director must regularly monitor the implementation of the plan to ensure that it remains reasonably likely to lead to a better outcome for the company. If that proves not to be the case, then the plan needs to be modified or the director must act to place the company into administration or take steps to wind it up.
As the safe harbour only applies to those debts incurred directly or indirectly in connection with the turnaround plan, the director must monitor the debts being incurred.
The turnaround plan must be documented as should all significant decisions in relation to its implementation/modification.
The director must continue to comply with all the usual director duties.
The director must ensure that he/she complies with any formal requests, made by any subsequently appointed liquidator, administrator or controller, for the books and records of the company.

Ipso facto reform

As well as creating a safe harbour for directors, the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 stays the enforcement of ipso facto clauses that are triggered by the appointment of a voluntary administrator, the appointment of a managing controller over all or substantially all of the company's property or where the company is undertaking a scheme of arrangement for the purpose of avoiding being wound up in insolvency.

An ipso facto clause in a contract is a provision which allows one party to terminate (or to alter the terms of) the contract on the basis of the occurrence of a certain event such as the financial position of the other party.

Such termination rights pose a serious impediment to the restructuring of companies that are in financial difficulties. Where the goodwill of a company is wholly or substantially based on the continued operation of certain contracts, an early termination will destroy the value of the company to such an extent that a restructure may become impossible.

The ipso facto protections will apply only to rights arising under a contract, agreement or arrangement entered into after 1 July 2018. Arguably, the application of the stay to rights arising under new contracts will limit the effectiveness of the ipso facto reform as contractual counterparties may avoid entering into new contracts by varying existing contracts. While a wide regulation-making power has been included as an anti-avoidance provision to allow the Government to respond to agreements which are specifically prepared in a way that seeks to circumvent the stay, that may not be wholly effective.

The stay will not prevent a counterparty from enforcing a contractual right where the company has failed to meet its payment or other obligations under the contract.

As the quid pro quo, where a stay applies, any obligation that a counterparty has to make a new advance of money or credit cannot be enforced during the period in which the counterparty's rights are stayed.

What rights are stayed and when?

The Bill introduces a regime for the stay of enforcement of ipso facto provisions in three circumstances:

the company is undertaking a scheme of arrangement (but only if it is entered into for the purposes of the company avoiding being wound up in insolvency);
a managing controller is appointed over all or substantially all of the company's property; and
the company enters into voluntary administration.

In each instance, the stay prevents enforcement of a contractual right that amends or terminates an agreement because of:

the company undertaking the scheme or being subject to the appointment of a managing controller or voluntary administrator; or
the company's financial position while subject to any of those types of formal insolvency.

How long does the stay last?

The stay on enforcement will run:

in a scheme of arrangement: from the date on which an application under section 411 of the Corporations Act is made, until the date that the application is withdrawn or dismissed, or the approved scheme comes to an end or the company is wound up;
where a managing controller has been appointed: from the time of the managing controller's appointment until the end of the managing controller's control; and
in voluntary administration: from the time the company comes under administration until the administration ends, unless the administration ends because the company is wound up in which case the stay remains in place.

In each of these cases, the court may order an extension of the period of the stay if it is satisfied that it is in the interests of justice to do so.

What happens when the stay ends?

Rights may be unenforceable indefinitely after the formal insolvency where they relate only to the company's formal insolvency or its financial position before or during the formal insolvency.

Rights not subject to the stay

The stay on enforcement does not apply:

if the Court orders otherwise;
if the administrator, managing controller or scheme administrator consents;
to contracts which are entered into after the date of the order approving the scheme, the appointment of the managing controller or the company coming under administration;
in a type of contract specified in the regulations or prescribed by Ministerial determination; or
to rights of a kind declared by Ministerial determination still to be enforceable.

The stay will not apply in circumstances where it would be contrary to the Payment Systems and Netting Act 1998 and the International Interests in Mobile Equipment (Cape Town Convention) Act 2013.

The prohibition on the exercise of rights under ipso facto clauses does not extend to secured creditors who have a security interest over the whole or substantially the whole of the company's property, permitting them to enforce their rights during the "decision period' in any voluntary administration.