Early guidance on safe harbour: zombie companies need not apply

The safe harbour against insolvent trading liability for directors has been in place since 19 September 2017.1 It was introduced to provide directors with an incentive to try to save their businesses, even if they had a suspicion of insolvency, by providing a defence where they took one or more courses of action that are reasonably likely to lead to a better outcome for the company than simply putting the company into liquidation.2 During the 2020 pandemic, the government also introduced what is effectively a ban on insolvent trading liability through a new COVID safe harbour,3 which is due to finish at the end of 2020. This note is concerned with the regular safe harbour that has been in operation since 2017 and will continue to operate in 2021 and beyond. The discussion below argues that the safe harbour is not helpful for SMEs because most of them won’t comply with the pre-conditions. I also argue that the new Part 5.3B is likely to be little used for the same reason.

Is the safe harbour working?

How are we to judge the success or failure of the safe harbour? The amendments that introduced the new law into the Corporations Act 2001 (Cth) required a review to be undertaken as soon as practicable within 2 years of its introduction.4 In normal circumstances we should have received the results of this review by now, but COVID-19 has quite understandably taken priority with Treasury’s resources. Hopefully, circumstances will permit the review to be undertaken in 2021. 

The anecdotal evidence as to the efficacy of the safe harbour is limited, with the Australian Institute of Company Directors finding in a survey of members . The TMA/KordaMentha Turnaround survey in 2019 found that almost half of respondents believed that the safe harbour has had no impact on the restructuring environment, which was almost double the number of respondents in the 2018 survey, so with a year’s further experience with the procedure more TMA members believed that the safe harbour would have no impact.5 A review of external administrations by McGrathNicol in 2019 also found limited evidence of safe harbour engagements in the firm’s matters, and where it was found it was far more likely in ASX listed companies, with less than 5% of matters involving SMEs including directors seeking safe harbour advice.6 

A survey of ARITA members by Professor Ramsay and Steele from the University of Melbourne in August 20197 found that less than 1/3 of respondents had any experience with the safe harbour and of those that did the vast majority stated that safe harbour work constituted less than 20% of their restructuring, insolvency and turnaround engagements, and most of those (24 respondents) had recommended the safe harbour between 2 and 6 times. The survey also revealed small numbers of successful restructures resulting from the safe harbour and a majority view of respondents that the safe harbour reforms had not achieved the government’s aims of achieving more successful restructures and promoting entrepreneurship by business people. There was a clear belief that the safe harbour is more appropriate for the big end of town rather than SMEs.8 The AICD reports that many small businesses find it difficult to obtain advice on the safe harbour because of their constrained financial circumstances, and also because many small business accountants have limited knowledge of the safe harbour provisions.9

One of the themes of the Ramsay and Steele survey was a concern by ARITA members about who could give safe harbour advice. The safe harbour law states that advice from an appropriately qualified entity may be a relevant consideration for the court when considering whether the directors took action that was reasonably likely to lead to a better outcome for the company.10

There are differing views on who these ‘safe harbourmasters’ should be, which largely reflect the vested interests of professional associations. Some argue that liquidators are best placed to give safe harbour advice, while other believe that this role should not be limited to liquidators because directors (particularly for SME directors with tight budgets for external advice) need flexibility. An external advisor might not be needed if the company already has a chief restructuring officer in place. Although it is clear that the law does not mandate external advice be obtained, the marketplace of professional advisors is crowded with firms promoting their skills as safe harbourmasters. 

Thankfully, we are starting to receive guidance from the court about how the safe harbour might work. 

Judicial consideration

In the recent decision in Re Balmz Pty Ltd (in liq) [2020] VSC 652, the court rejected the following argument by the managing director of a small café business in Melbourne that the safe harbour defence should apply to insolvent trading claims by the liquidator because: 

‘if the director starts to put together a plan that has a chance of putting the company in a better position … that plan can be implemented and the company turned around, the directors will not have to be concerned about the prohibition on insolvent trading.’ 

In this case, the café business had difficulty paying its creditors over a prolonged period. The company’s computer records were destroyed due to a computer malfunction, and the managing director simply could not cope so the company stopped filing tax forms, got behind on its employee tax obligations (including superannuation), and the tax debts and associated penalties ballooned to over $100,000. Other creditors were paid on an ad hoc basis, and several creditors threatened legal action. The company engaged a business advisory firm that promoted itself as assisting with tax disputes, but the director provided no evidence of what advice the firm provided. The ATO issued garnishee notices and applied for a winding up order.

It was clear that the company had been insolvent for several years, although the directors argued that it was solvent because they had sold personal assets to pay suppliers to keep the business going, and had dipped into their super to do so. Indeed, the directors were the single largest creditor in the company’s insolvency. Despite such action, many creditors (particularly the ATO) went unpaid for prolonged periods.

The court held that the safe harbour was not available because the company had outstanding tax lodgements, had not paid employee entitlements and the directors had failed to point to what action they had taken that was reasonably likely to lead to a better outcome for the company. As the saying goes, hope is not a strategy.

Key takeaways from the case:

  1. before engaging a safe harbour advisor ensure that tax lodgements and employee entitlements are up to date;
  2. keep a record of the terms of engagement with the safe harbour advisor;11
  3. keep a record of what particular actions have been taken to attempt to provide a better outcome for the company to come within the protection of the safe harbour. 

It goes without saying that an ounce of prevention is worth a pound of cure. Ensuring that the company’s books and records are kept up to date is an essential foundation for tracking revenue and expenses, which in turn will facilitate keeping tax lodgements up to date and the proper payment of employee entitlements. Of course, cash(flow) is king, and many small businesses don’t maintain proper books and records because of time and financial constraints and because of a lack of will to do so. How many profit margins are based on non or underpayment of tax and employee entitlements? The ATO is not called the biggest financier to small business for no reason. 

The Re Balmz case is a useful illustration of the problems faced by many small businesses and shows how irrelevant the safe harbour is for the majority of small businesses, and how unlikely the new Pt 5.3B is to help most small business.12 Neither of these law reforms are aimed at fixing the real problem in the economy, the inability of small businesses to face up to their financial problems in a timely way. Rather than adding further complexity to the law, we need the Government to implement the ASBFEO proposal to provide a business viability review program so that businesses can get a financial check-up.13

An ounce of prevention is worth a pound of cure.

References 

  1. For background on the safe harbour see: Harris, ‘Reforming insolvent trading to encourage restructuring: Safe harbour or sleepy hollows?’ (2016) 27 Journal of Banking and Finance Law and Practice 294; Anderson, ‘Shelter from the Storm: Phoenix Activity and the Safe Harbour’ (2018) 41(3) Melbourne University Law Review 999; Edwards, ‘Australia’s Safe Harbour Law – A Better Outcome for Restructuring and Entrepreneurship?’ (2019) 27 Insolvency Law Journal 66. 
  2. Corporations Act 2001 (Cth) s 588GA(1). 
  3. Corporations Act 2001 (Cth) s588GAAA. 
  4. Corporations Act 2001 (Cth) s 588HA. 
  5. https://www.kordamentha.com/insights/KordaMentha-TMA-Australia-Survey-2019
  6. Brauer, ‘Safe Harbour in Practice’ (2019) 32 ARITA Journal 31-32.
  7. Ian Ramsay and Stacey Steele, The ‘Safe Harbour’ Reform of Directors’ Insolvent Trading Liability in Australia: Insolvency Professionals’ Views (2020) 48 Australian Business Law Review 7, available for download at https://poseidon01.ssrn.com/delivery.php? 
  8. See also Michael Murray, Is Australia’s insolvency safe harbour protection working – who knows?, Murray’s Legal Commentary, 30.10.20 https://murrayslegal.com.au/blog/2020/10/30/is-australias-insolvency-safe-harbour-protection-working-who-knows/ 
  9. Christopher Niesche, How safe harbour reforms are tracking two years on, 1.10.19, https://aicd.companydirectors.com.au/membership/company-director-magazine/2019-back-editions/october/safe-harbour
  10. Corporations Act 2001 (Cth) s588GA(2)(d). 
  11. See also Habrok (Dalgaranga) Pty Ltd v Gascoyne Resources Ltd [2020] FCA 1395 (http://classic.austlii.edu.au/au/cases/cth/FCA/2020/1395.html
  12. See https://australianinsolvencylaw.com/2020/10/09/a-new-system-for-sme-restructuring/
  13. See Eddie Griffith, Business Viability Review-Essential for Small and Family Businesses, https://abrt.org.au/business-viability-review/. This was recommended by the ASBFEO report, Insolvency Practices Inquiry, 2020.

One response to “Early guidance on safe harbour: zombie companies need not apply

  1. Thanks Jason. On the prescribed statutory review of Safe Harbour, it should have happened as soon as possible after September last year, so COVID is not a complete excuse for the delay as it should at least have been put in train before COVID.

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