A Safe Harbour In Uncertain Waters

Section 588G of the Corporations Act 2001 (Cth) (the Act) places a duty on a director to prevent the company from incurring a debt where there are reasonable grounds for suspecting the company is, or would become, insolvent. If a director is found to have breached this duty, they can be personally liable for the insolvent trading of the company.

The ‘safe harbour’ provisions protect a director from liability under section 588G where:

1. the director develops a course of action that is reasonably likely to lead to a better outcome for the company; and

2. the debt is incurred directly or indirectly in connection with that course of action.

In determining whether a course of action is reasonably likely to lead to a better outcome for the company, the Court will have regard to whether the person has:

a) properly informed themselves of the company’s financial position;

b) taken appropriate steps to prevent misconduct by officers and employees;

c) taken appropriate steps to ensure the company is keeping appropriate financial records;

d) obtained advice from an appropriately qualified entity which, depending on the particular circumstances of the company, could be an accountant, a lawyer or an insolvency practitioner; or

e) developed or implemented a plan for restructuring the company to improve its financial position.

The Explanatory Memorandum to the Amending Law has helpfully indicated that ordinary trade debts incurred in the usual course of business will attract the protection of the ‘safe harbour’ where a qualifying ‘course of action’ is developed and implemented. This allows a director to continue trading the company as normal whilst implementing a strategy towards a better outcome. Further, the Explanatory Memorandum indicates the ‘course of action’ does not necessarily have to be successful. Where the director develops a course of action but the company still fails, proceeding to voluntary administration or liquidation, the director does not automatically lose the benefit of the ‘safe harbour’.

Importantly, the ‘safe harbour’ will not apply where the company has not paid employee entitlements, has not complied with tax obligations or has not met its obligations to report and provide books to an external administrator, liquidator or managing controller appointed to the company.

We regularly provide advice to company directors who also hold executive positions, are shareholders and are directly responsible for the strategic and ‘day to day operation’ of a company. These directors have to balance the difficult task of continuing to trade the company, often in an attempt to realise their own investment, whilst contending with the prospects of facing personal liability for insolvent trading. In the opinion of many commentators, including the Australian Institute of Company Directors, prior to the introduction of the Amending Law, the provisions in the Act had the effect of incentivising the entry into voluntary administration in circumstances where it may not have been entirely necessary. The argument is founded on the view that directors see little choice when faced with the alternative of personal liability.

In the case of McLellan (in his capacity as liquidator of The Stake Man Pty Ltd) and Another v Carroll (2009) 76 ACSR 67, Mr Carroll was the sole director of a company which operated a business of processing and wholesaling timber. The company was by all accounts successful and profitable until it sought to expand its operations through the purchase and installation of a new piece of equipment to provide an expanded market offering. Unfortunately, the suppliers of this technology appeared to underestimate the costs involved in the project and the equipment largely failed to perform as required in what turned out to be a highly unsuccessful and expensive venture for the company.

Mr Carroll attempted to rectify the problems encountered with the equipment. However, the company’s financial position worsened as it remained unable to market any of the new product. Mr Carroll and his business partner injected personal funds into the company to maintain some level of cash flow. The large amount of stock awaiting treatment with the equipment gave Mr Carroll and the company’s accountant the belief the company remained solvent. Mr Carroll sought advice from both an insolvency practitioner and a consultant in an attempt to find an investor to inject further capital into the company. After seemingly being unsuccessful in finding any external sources of finance, and on the advice of the insolvency practitioner, Mr Carroll placed the company in voluntary administration.

Despite the assurances of the company’s accountant that the company had remained solvent, the Federal Court found the company had incurred debts whilst insolvent. The Federal Court had little option but to find Mr Carroll had breached his duty under s 588G. However, he avoided personal liability on the basis of a discretionary power of the Court (section 1317S(2) of the Act) which allows an application for relief where a person has acted honestly in the circumstances of the case.

It seems appropriate that, if this matter were heard again today, the Federal Court could consider the actions of Mr Carroll (including injecting additional funds, seeking professional advice and assistance and engaging advisors to raise new capital) to determine whether this ‘course of action’ was reasonably likely to lead to a better outcome for the company. Assuming Mr Carroll advanced evidence that he had developed a plan to attract an investor and utilise an injection of funds to steer the company out of financial difficulty, it is quite possible he would have been found to have taken some of the required steps to afford him the protection of the ‘safe harbour’. However, until we receive guidance from the Court as to how the safe harbour is to be implemented in practice, it is difficult to determine exactly what is required to afford this type of comfort to directors of struggling companies or if the uncertainty will continue to result in the early entry into voluntary administration.

SWS has been assisting private company directors to formulate practical and documented ‘courses of action’ in an effort to invoke the ‘safe harbour’ since its inception late last year. We consider the steps directors need to take to avail themselves of the ‘safe harbour’ provisions will differ on a case by case basis. However, it is our submission that some of the steps taken by Mr Carroll, in an honest and pragmatic attempt to save his company, will (in time) comprise some of the recognised indicia of the ‘safe harbour’ for the purposes of the new provisions.

This article is not legal advice.  It is intended to provide commentary and general information only.  Access to this article does not entitle you to rely on it as legal advice.  You should obtain formal legal advice specific to your own situation.  Please contact us if you require advice on matters covered by this article.

This article was co-written by Litigation Lawyer, Scott Homan.