Good news for Australian company directors on personal liability risk

Australian company directors may soon have the comfort of a ‘safe harbour’ exclusion to the insolvent trading provisions of the Corporations Act 2001 if proposed amendments, introduced into parliament on 1 June, are passed.

It is well established that Australian directors may become personally liable for any debts incurred by a company if there were reasonable grounds to suspect that the company was insolvent or may become insolvent.

And this risk is not remote. It is very real. It is commonplace for directors to be sued by motivated liquidators armed with the benefit of hindsight and looking to deliver returns to aggrieved creditors.

Insolvency laws place enormous pressure on boards looking to steer a company through financially difficult times and on one view, raise a conflict between the personal interests of a director and the interests of shareholders.

Faced with the prospect of personal liability, directors are more likely to seek voluntary administration despite there being prospects of financial recovery.

Industry groups have long denounced these laws as draconian − acting as a deterrent to quality candidates from accepting board positions.

These complaints appear to have been heard by the Government which has acknowledged that insolvent trading laws put too much focus on stigmatising and penalising failure.

Safe harbour in certain circumstances

The good news is that directors may soon have the comfort of a ‘safe harbour’ exclusion to the relevant insolvent trading provisions of the Corporations Act.

In an effort to promote a culture of entrepreneurship and innovation, the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Bill 2017 was read into the House of Representatives on 1 June which protects directors from personal liability for the company’s debts in certain circumstances.

The reforms provide 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.

Notably, the legislators intend to make this exclusion available only to those directors who have taken appropriate steps in all other aspects of running the company, including proper records/books maintenance, compliance with taxation reporting obligations and provision for employee entitlements (including superannuation).

The explanatory memorandum of the bill explicitly acknowledges that the question of whether a course of action is reasonably likely to lead to a better outcome for the company will vary on a case basis, noting that directors operate in a rapidly changing and uncertain environment, often without the benefit of complete information, and may consider a range of options in the process of settling on a particular course of action.

The bill sets out a non-prescriptive list of factors that a Court may consider. It includes whether the person has:

  • Kept themselves informed about the company’s financial position.
  • Taken steps to prevent misconduct by officers and employees of the company.
  • Taken appropriate steps to ensure the company maintained appropriate financial records.
    obtained appropriate advice from an appropriately qualified adviser.
  • Been taking appropriate steps to develop or implement a plan to restructure the company to improve its financial position.

This useful checklist highlights the need for detailed and accurate record keeping and the creation of contemporaneous records of decision making processes. But it is only a guide and if a director fails to react appropriately to changed circumstances that indicate the company is not viable, he or she will no longer have the benefit of the ‘safe harbour’ protection for any debts incurred going forward.

The ‘reasonableness’ test

A director will bear the evidentiary burden of establishing an entitlement to the ‘safe harbour’ exclusion, and will need to present evidence that he or she took a course of action that was reasonably likely to lead to a better outcome for the company and its creditors.

The onus of proof then shifts to the liquidator (or other party) plaintiff , who will bear the legal burden of establishing, on the balance of probabilities, that the course of action being taken was not reasonably likely to lead to a better outcome for the company.

If the bill is enacted in its current form, it is expected to generate a significant amount of legal submission and courtroom debate on concepts such as ‘better outcome’ and ‘reasonable likelihood’.

While 'better outcome' is defined to mean one where the company and its creditors as a whole are better off than the company becoming an externally administered body corporate, it is still unclear what would be considered ‘better’ especially when assessing contingent or non-monetary outcomes that may represent some value to creditors.

The overall difficulty, as we see it, will lie in assessing the alternative outcomes of any particular scenario, which, inevitably will be somewhat speculative in nature.

Other jurisdictions offer little guidance on this point. Corporate and bankruptcy laws in the US, for example, do not even have an insolvent trading provision. The closest to the ‘safe harbour’ exclusion is the provision of the UK’s Insolvency Act , which states that a director will not be liable for ‘wrongful trading’ unless he/she failed to take "every step" to minimise loss to the company's creditors.

However, given that the Australian bill introduces a test of ‘reasonableness’, which will be assessed objectively, it would allow a wider application (compared to the UK version), allowing directors sufficient scope to take a course of action that is reasonably appropriate, taking into account the company's size, nature and complexity of situation.

This article touches on only one aspect of proposed legislation, which is well worth a closer look for those with an interest in this area. We will continue to monitor the passage of (and any amendments to) this bill through the House of Representatives and in due course, the Senate.