26 Nov 2015

Safe harbour for directors will not save more companies

by Karen O'Flynn

It's unclear that safe harbours by themselves will provide genuine opportunities for restructuring distressed businesses.

The Productivity Commission's upcoming report on corporate insolvency will address two burning issues: ipso facto clauses and how to encourage directors to save financially-stressed companies.

Ipso facto clauses allow creditors to break a contract if the other side suffers an insolvency event. If that results in a company being starved of supplies or customers, the chances of successfully restructuring its debts are greatly reduced.

There is much support for abolishing or restricting the use of ipso facto clauses. Conversely, there are two reasons why such a change might not be enacted or, if enacted, might be ineffective: the principle that the law should be slow to interfere with freely-negotiated contracts, and the possibility that clever drafters might write contracts that achieve the same effect as ipso facto clauses, without breaching the prohibition.

The debate about ipso facto clauses pales into insignificance compared to the discussion about how to encourage directors to try to save their companies.

We already have a statutory regime ‒ voluntary administration ‒ which allows directors to appoint an external expert to explore ways of saving their company. This also shields the directors from personal liability for corporate debts.

Unfortunately, voluntary administration is often just the scenic route to insolvency. Broadly speaking, there are two schools of thought on why this is so.

There are those who believe that voluntary administration is part of the problem, rather than the solution: directors, it's claimed, appoint voluntary administrators more to avoid personal liability than to find a way to save their company.

The opposing view is there's not much wrong with voluntary administration: corporate failures are just the free market at work, and it's not surprising that, by the time an administrator is appointed, many struggling companies are beyond hope of rescue. Part of the problem, it is suggested, is that directors are too slow ‒ not too quick ‒ to appoint an administrator.

The Productivity Commission's draft report suggested a new form of corporate rescue: a personal liability "safe harbour" period for directors during which they could seek professional advice on how to restructure their company and its debts.

But would this increase the number of successful restructures? As the Queensland University of Technology Centre for Commercial and Property Law pointed out in its submission to the Commission, much of this debate takes place in an information vacuum.

Statistics about the effectiveness of voluntary administration are hard to come by. Equally importantly, there is next-to-no accurate (as opposed to anecdotal) information on how directors actually think and behave in a financial crisis. Without that information, the idea that a safe harbour will save more companies is largely based on hope.

But why not just give the safe harbour proposal a run, to see if it works? The problem is that, every time another protection is extended to directors, someone else (in this case, creditors) suffers a corresponding detriment. Before further crimping their legal rights, we owe it to creditors to ensure that its adverse impact on them will be minimal.

One objective of the Australian corporate insolvency regime is to provide genuine opportunities for restructuring distressed businesses. The available evidence demonstrates that, the earlier in the distress cycle the turnaround professionals (including lawyers) are retained by directors, the more likely the rehabilitation of the struggling enterprise. It may be that acceptance by directors of this simple fact will do more to enhance a restructuring culture than any legislative change.

This article was first published in the Australian Financial Review on 13 November, 2015.


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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.