Insolvent Trading Law Reform April 2010 Carl Gunther

Carl Gunther April 2010

On 19th January 2010, the Government announced it was considering making changes to
the operation of the insolvent trading provisions. The author discusses the proposals that
were put forward and evaluates the arguments for and against reform in this area.

Table of contents
1 Introduction:...................................................................................................................... 2
2 Insolvency in the Australian context ................................................................................. 3
2.1 Insolvency defined ................................................................................................... 4
2.2 Director’s duties and insolvency. ............................................................................. 5
2.3 Civil defences to and relief from proceedings of insolvent trading......................... 5
2.4 Informal v’s formal restructuring in the context of Australian insolvency .............. 6
2.5 Safe harbour............................................................................................................. 9
2.6 A case for changing the insolvent trading provisions of the Law ............................ 9
3 Discussion of options....................................................................................................... 10
3.1 Option 1: the case for Status quo .......................................................................... 10
3.1.1 Defences – Section 588 H of the Act. ................................................................ 10
3.1.2 Relief from insolvent trading provision. ............................................................ 11
3.1.3 Summary of the case for Option 1: Status quo ................................................. 12
3.2 Option 2: the case for a Modified Business Judgement Rule ............................... 13
3.2.1 The current business judgement rule................................................................ 13
3.2.2 Proposed modifications to the Business Judgement Rule ................................ 14
3.2.3 Summary of the case for a Modified Business Judgement Rule ?..................... 16
3.3 Option 3 – the case for a Moratorium from the insolvent trading laws?.............. 17
4 Other observations about the Treasury Discussion Paper.............................................. 17
5 Bibliography..................................................................................................................... 19

1


1 Introduction:
“I don’t live in fear that I will be found out, but that it will take seven years in the
courts to prove it”1 quoted David Gonski, Chairman of Coca-cola Amatil on the
matter of personal liability arising from laws with regards to Director’s duties. It’s
not the laws themselves that Gonski has a problem with, its the way they are
enforced.

Personal risks to directors are significant
The personal risks to directors associated with seeking to restructure the affairs of a
company outside of a formal insolvency are significant. Some commentators suggest
the laws in Australia regarding insolvent trading genuinely stifle informal
restructuring because of the personal risks. Whilst the likes of David Gonski suggest
it’s the way the laws are prosecuted that present the real problem rather than the
laws themselves.

Treasury Discussion Paper
In January 2010, the Minister for Financial Services, Superannuation and Corporate
Law, Mr Chris Bowen, announced the release of a discussion paper (Insolvent
trading: A safe harbour for reorganisation attempts outside of external
administration January 2010) (“Treasury Discussion Paper”) on the operation of
Australia's insolvent trading laws in the context of attempts at business rescue
outside of external administration.

The Minister put forward 3 options as proposals for discussion:
Option 1: Status quo- that is no change to the law. Directors need to ensure
that their company is solvent whilst undertaking an informal restructuring.

1
Gonski, David Australian Securities Investments Commission Annual Policy Summit
Melbourne February 18 2008

2


Option2: Modified business judgement rule: Director’s duty would be
satisfied with the application of a prescriptive modified business judgement
rule which supplements the requirements of S180 of the Corporations Law.
Option 3: Moratorium: A limited moratorium period from the duty not to
trade whilst insolvent for the purpose of attempting an informal
reorganisation of the company.

This paper considers all three options and the arguments for and against.

A case for change
Having considered in this paper the circumstances of each option, there would
appear to be a strong case for changing the insolvent trading laws in a way that
supports informal restructuring. A safe harbour approach in the form of a modified
Option 2 would appear to be the most appropriate means by which informal
restructuring could be implemented. Any changes need to be considered in the
context of all stakeholders, not just directors and shareholders.

2 Insolvency in the Australian context
The insolvent trading laws in Australia create a defining point at which a company
must seek to reorganise its affairs either formally or informally. A formal restructure
in this paper is defined as one where the company’s affairs are placed under the
control of an external administrator, receiver or liquidator who applies formal
reorganisation procedures provided for in the Corporations Act 2001 (“the Act”). An
informal restructure is one where the company’s affairs remain under the control of
its directors without recourse to the formal reorganisations procedures in the Act.

In many cases, the directors will make the decision as to which route to follow and in
concluding their decision they will certainly be considering (amongst many factors)
their duties and personal liability as it applies under the law.

3


2.1 Insolvency defined
The Act defines a person as “insolvent” if they are not “solvent”.2 It further defines a
solvent person as one able to pay all of their debts as and when they become due
and payable. An insolvent company is therefore a company that is unable to pay all
its debts when they become due and payable.

The concept of insolvency is derived from legislation and case law precedents. The
primary test to ascertain insolvency is applied using a company’s cash flows.
Australian courts have also examined certain other commercial and financial issues
including the state of a company’s balance sheet when examining whether directors
may have been guilty of allowing a company to trade from the time it became
insolvent.

Whilst a review of case law on the tests of insolvency is beyond the scope of this
paper, it is worth noting the following 2 important points:

1 the Courts in considering the meaning of insolvency have stated that “A
temporary lack of liquidity does not necessarily mean insolvency”.3 Ultimately
directors need to determine if the company’s illiquidity is temporary or
permanent. At any point in time, decisions about liquidity will be based upon
future outcomes; in a time-pressured environment. Unfortunately the courts
judge a director in hindsight once those outcomes are known.
2 An insolvent company is sustained through the funding of the company’s
creditors. If the creditors are funding the company then from a directors
perspective “the interests of the company are, in reality the interests of existing
creditors alone”4. That is, creditor interests effectively become paramount to the
interests of all other stakeholders because the risk of failure shifts to a company’s

2
Corporations Act 2001 s 95A
3
Sandell v Porter (1966) 115 CLR, 666, 40 ALJR7
4
Brady v Brady (1987) 3 BCC 535,552 (Nourse LJ)

4


creditors. The law imposes very stringent duties upon directors towards
creditors in circumstances of insolvency.

2.2 Director’s duties and insolvency.
Directors are subject to a number of duties derived from common law and the
statutes. For example, they must exercise their powers and discharge their duties
with care and diligence5. Under the Act s588G, directors have a duty to prevent a
company from incurring further debt (hereafter defined as trading whilst insolvent) if
it becomes or is at significant risk of becoming insolvent. It’s a positive duty under
the Act; the company must remain solvent at all times even whilst it’s undertaking
informal restructuring. The application of the duty to prevent insolvent trading is set
out in the Act 588G (1). A failure to prevent insolvent trading can result in civil
penalties, disqualifications and orders to pay compensation.6 Criminal liability may
also arise if a director suspected at the time the company incurred the debt that the
company was insolvent7. The implications for directors who trade whilst the
company is insolvent are therefore significant.

2.3 Civil defences to and relief from proceedings of
insolvent trading.
There are “mechanisms” under the Act that provide directors with a defence to and
relief from the insolvent trading laws. They are discussed in detail in section 3 of this
paper however in summary a director can rely upon a number of defences contained
in the Act s 588H and in the Act ss1317S, 1318 the courts may excuse a director from
civil breaches.

5
Corporations Act 2001 S 180 (1)
6
Corporations Act 2001 Part 9.4B
7
Corporations Act 2001 Section 588 G (3)

5


2.4 Informal v’s formal restructuring in the context of
Australian insolvency
Having defined “formal” and “informal” restructuring, in the context of the options
presented by the Minister, its worth discussing briefly the circumstances giving rise
to each type of restructuring and when they are typically deployed.

Fig 1 below graphically represents a conceptual view of circumstances giving rise to
the two types of restructuring.

At KPMG 8 this graph is referred to as the Director Decision Demise curve.

In considering Fig 1, the following observations are made:
1. A “successful” informal restructuring will almost always result in a better
financial outcome to stakeholders compared to a formal restructuring. This is

8
The author is a Director in KPMG’s restructuring Advisory practice. The views of the author
are not necessarily the views of KPMG.

6


because a formal restructure will have a material adverse impact on asset
carrying values.
2. “Unsuccessful” informal restructuring activities normally result in insolvency.
3. In concluding their decision as to which route to follow (informal v formal
restructuring), what often weighs most on the minds of directors is their
personal liability as it applies under the law.
4. The timing of intervention statistically appears to have a major role to play.
The earlier a director intervenes on the demise curve, the more likely an
informal restructuring will be successful.
5. The longer a director takes to intervene, the less control they have over the
outcome and hence the less likely an informal restructuring will be
successful.

There does not appear to be a way of measuring the success of informal
restructuring using publicly available data as most informal restructuring programs
are conducted in secret and not reported.

One proxy for a measure of successful formal restructurings is available by
comparing the number of companies that successfully execute a Deed of Company
Arrangement (“DOCA”) under Part 5.3A of the Act , against the number of companies
that enter some form of insolvency administration. This conclusion can be drawn
since a DOCA is a deal agreed by a company with its creditors as part of the
Voluntary Administration procedure.

7


Fig 2: Insolvency Works Business Stress Report Oct 2009.

Using data obtained from the Australian Securities Investment Commission, advisory
firm; Insolvency Works Pty Limited compiled statistics which form the basis of Fig 2
above. With reference to Fig 29, only 7.3% of companies entering some sort of
insolvency administration successfully executed a DOCA in the year to October 2009.
There has been a decline from 14.2% in 1999 to the current level.

The above statistic is a controversial reference point due to the number and volume
of liquidations during the period. However a conclusion that can be made is that the
success rate in formally restructuring insolvent companies is low and there is a case
for changing the law to improve restructuring outcomes.

This argument is reinforced in a joint submission to the Treasury Discussion Paper
between the Law Council of Australia, the Insolvency Practitioners Association of
Australia and the Australian Chapter of the Turnaround Management Association
(“Joint Submission”) discussed at section 2.5 below.

9
Insolvency Works - Business Stress Report October 2009.

8


2.5 Safe harbour
The concept of a safe harbour from insolvent trading laws was tabled in the Treasury
Discussion Paper on the basis that it (the safe harbour) assisted directors concerned
about personal liability when choosing either an informal or formal restructuring.
Options 2 and 3 of the Treasury Discussion Paper are types of safe harbour
mechanisms.

In the Joint Submission there were 5 policy reasons sited as to why a safe harbour
should be in place to allow informal restructuring:
1 The existing law, without any safe harbour, can impede or prevent proper
attempts at informal workouts.
2 Without any safe harbour, the existing laws have a major effect on honest,
capable directors, particularly non-executive directors.
3 the focus of directors of a financially troubled company should primarily be (as it
is everywhere else in the world) on the interests of creditors.
4 The existing insolvent trading law limits the options available to deal with
financial distress.
5 A safe harbour defence would promote the policy objective of obliging directors
to obtain early restructuring advice.
These reasons are logical in their approach and lend weight to the concept of a safe
harbour for directors. If there are grounds for suspecting a company is insolvent, a
director faces an automatic personal liability for debts incurred post the date this is
determined. Honest and diligent directors will not breach the law and for this reason
they will unfortunately apply a “black and white” application of the law to a very
“grey” circumstance. Honest and diligent directors would therefore benefit from a
safe harbour approach to insolvent trading laws.

2.6 A case for changing the insolvent trading provisions
of the Law
Given that informal insolvencies result in a better stakeholder outcomes than formal
insolvencies and that the success rate in formally restructuring insolvent companies

9


is low, there would appear to be a strong case for changing the insolvent trading
laws in a way that supports informal restructuring. The adoption of a safe harbour
approach appears to be consistent with other jurisdictions and there are clear policy
reasons for doing so.

3 Discussion of options

3.1 Option 1: the case for Status quo
As stated previously, there are “mechanisms” under the Act that provide both a
defence to and relief from the insolvent trading laws. A director can rely upon 4
defences contained in the Act s 588H and under the Act ss 1317S, 1318, the courts
may excuse a director from civil breaches of the Act.

3.1.1 Defences – Section 588 H of the Act.
To defend an action under the Act s 588H, a director must prove:
• 588H (2) – they had reasonable grounds to expect solvency. When the debt was
incurred the director had reasonable grounds to expect that the company was
solvent and would remain solvent if the debt was incurred. This requires more
than a mere hope or possibility10.
• 588 H (3): That when the debt was incurred the director had reasonable grounds
to believe and did believe that a subordinate was competent, reliable and
responsible for providing adequate information about the company’s solvency
and the directors expected on the basis of this information that the company was
solvent and would remain solvent. This section does not negate a director’s duty
to keep themselves informed and to form their own judgement about the affairs
of the company11.

10
Tourprint pty ltd (1999) 17 ACLC 1,543, [67]
11
Manpac Industries P/L v Ceccattini (2002) 20 ACLC 1,304

10


• 588 H (4) : That at the time the debt was incurred they were absent from
management for illness or good reason. A director will not have a good reason
merely by not participating in the company’s business12 .
• 588 H (5): that all reasonable steps to prevent the debt being incurred were
taken.

The Act s 588 H (6) makes reference to actions a director can take to prove a defence
under s 588 H and they include the director appointing an administrator of the
company.

Whilst these defences appear to be quite broad, it appears from case law that the
courts have interpreted the defences under the Act s588H quite restrictively.
13
Ultimately the burden falls on the director to establish a defence and as Gonski
said, it can take years to prove or defend one’s position. For this reason the defences
provide little comfort to a director when consider their personal position particularly
at the time a decision has to be made to consider a restructuring plan.

3.1.2 Relief from insolvent trading provision.
If it is found that a person has contravened a civil provision of Act, the courts may
under the Act ss 1317S, 1318, relieve the director wholly or partially from civil
liability.

The provisions do not provide defences to the insolvent trading laws. All they do is
empower the court to relieve an officer from civil consequences of a breach if the
director has acted honestly having regard to all the circumstances. The onus of
proof is placed on the director to apply to the court.

12
Tourprint pty ltd (1999) 17 ACLC 1,543, [67]
13
Byron v Southern Star Pty Ltd (1997) 15 ACLC 191.

11


There is little case law in respect of the operation of the Act ss 1317S,1318, with
respect to insolvent trading. However for the first time, a judge in 2009 provided a
director with complete relief from civil penalty following a finding of insolvent
trading in the matter of Stake Man Pty Ltd v Carroll [2009] FCA 1415 14 (“Stake Man
Case”). It appears then that directors may potentially engage in insolvent trading and
yet avoid civil liability. Interestingly the judge in the Stake Man Case rejected all
defences put forward by the director under the Act s 588H. He sought to apply the
criteria established by Justice Palmer in Hall v Poolman [2007] NSWSC 133015 which
until recently was the leading authority on this issue, that in some cases it was
commercially sensible to allow a reasonable time for a director to assess whether
the company’s difficulty is temporary or fatal. Whilst the outcome in the Stake Man
Case was a relief for the director, it was a very expensive outcome as the judge
awarded costs against the director.

If there is any take away from both cases, its that its rare for a court to apply the Act
ss 1317S, 1318, in respect of the insolvent trading provisions.

3.1.3 Summary of the case for Option 1: Status quo
Given the risks associated with the insolvent trading provisions, a director is
compelled to place a company into administration under the Act s 588 H (6) where
they cannot form the requisite view as to an expectation of solvency, even in
circumstances where the interests of creditors might be better served by an informal
workout.

At the time when a director is considering a temporary or permanent illiquidity, it’s
difficult to envisage why a director would consider an informal restructure when the
defences and relief offered under the Act are weighed down by the heavy burden of
proof placed on the directors under the insolvent trading provisions.

14
Stake Man Pty Ltd v Carroll [2009] FCA 1415
15
Hall v Poolman [2007] NSWSC 1330

12


In conclusion, it would appear that the case for Option 1, that is, to keep the status
quo of the insolvent trading provisions of the Act would do little to advance the
cause for informal restructuring.

3.2 Option 2: the case for a Modified Business
Judgement Rule
The business judgement rule which operates in relation to the statutory duty of care
and diligence under the Act s 180, was introduced to protect the authority of the
director in the exercise of their duties and to clarify their liability. Importantly, the
Act s180, does not apply to the duty not to trade whilst insolvent imposed under the
Act s 588G. For this reason it has been proposed in the Treasury Discussion Paper
that the Act s180, be modified in a way to accommodate the insolvent trading laws.

3.2.1 The current business judgement rule
Before proceeding with a discussion on the proposed modifications in the Treasury
Discussion Paper its worth commenting on drafting of the Act s 180 (2).

A director has satisfied their obligations to exercise their powers and discharge their
duties with due care and diligence under of the Acts 180 (2) if they:
1 Make a business judgement in good faith for a proper purpose.
2 In respect of a matter in which they do not have a material personal interest.
3 After informing themselves about the subject matter of the judgement to the
extent they reasonably believe to be appropriate.
4 Rationally believe that the judgement was in the best interests of the
corporation.

In the Joint Submission, (referred to in section 2.4 and 2.5 above) , it was noted that
the Act s180 (2) (b) (in other words item 2 above) should be deleted or substantially
modified.

13


The rationale sited in the Joint Submission was that:
“Executive directors will often be employees of the company. Many will be
shareholders. They may also be creditors on director loan accounts and a
source of that additional capital may be one of the directors or interests
associated with that director”.
As a result, a director would not be entitled to a defence under the Act s 180 if the
above criteria existed. For this reason, the authors of the Joint Submission proposed
(the author of this paper also agrees ) that the Act s 180 (2) (b):
“ either be deleted, or should be subject to the proviso that none of the above
circumstances constitutes a "material personal interest" for the purposes of
the application of the rule to this defence to Insolvent trading”

3.2.2 Proposed modifications to the Business Judgement
Rule
At paragraph 5.3.6 of the Treasury Discussion Paper are 4 proposed modifications to
the business judgement rule that would apply in respect of the insolvent trading
provisions of the Act. They would operate so that directors would be relieved of the
duty not to trade whilst insolvent if the following elements are satisfied:
1 the financial accounts and records of the company presented a true and fair picture of
the company's financial circumstances;
2 the director was informed by restructuring advice from an appropriately experienced
and qualified professional with access to those accounts and records, as to the feasibility
of and means (“a plan”) for ensuring that the company remained solvent and that it was
returned to a state of solvency within a reasonable period of time;
3 it was the director's business judgment that the interests of the company's body of
creditors as a whole, as well as members, were best served by pursuing (informal?)
restructuring; and
4 the restructuring was diligently pursued by the director.

14


3.2.2.1 Modified business judgment rule- a true and fair view?
The objective that the accounts of the company present a true and fair view is to
ensure the financial information is meaningful and the basis of financial data for any
decision is accurate. However for the following reasons, a true and fair view of the
historical records of the company has a number of limitations:
1 Are the company’s records and accounts true and fair. The Treasury Discussion
Paper rightly refers to the situation where a “person seeking protection may be
required to engage in disputes as to the accuracy of financial records”.
2 Accounts that represent a true and fair view are historical in nature. The primary
test of insolvency is determined through the use of forward-looking cash flows-
that is, the ability of a company to pay its debts as and when they fall due. A true
and fair view would not present forward-looking cash flows.
3 Just because the accounts of a company are not True and Fair should not
preclude a company and the directors from attempting an informal restructuring.
In the Joint Submission at paragraph 5.10 (b), it was stated that the true and fair
view modification should be changed to reference “any information necessary for
the provision of restructuring advice”16. Since many factors are at play in forming an
opinion as to the success of otherwise of a restructuring plan, its important that the
modified rule remain sufficiently wide to accommodate the provision of
restructuring advice.

3.2.2.2 Modified business judgment rule- an appropriately
experienced and qualified professional?
The authors of the Treasury Discussion Paper sought to enforce the concept that
Directors ought to get independent advice. Case law supports the requirement to
seek advice however the question arises as to what actions if any the director should
take in adopting the advice given. For this modification to be meaningful, a director
should be required to follow the advice (or provide a good reason why they didn’t)
rather than merely seek it. This needs to be balanced against the need for directors
to exercise their own judgement not withstanding the advice given. It would be a

16
Paragraph 5.10 (b) of the Joint Submission

15


bold director to ignore, or worse, go against the advice of the appropriately qualified
professional under the modified business judgement rule.

In their submission to the Treasury, the contributors to the Joint Submission17 made
reference to and suggested that the modified rule:
“must accommodate the appointment by the company of appropriate
personnel with specialist skills, such as a chief restructuring officer (CRO)”.

A controversial move, since the CRO by default will become an officer carrying the
responsibilities of a shadow director! A move the author of this paper does not
support.

3.2.2.3 Modified business judgement rule- interests of the
company's body of creditors as a whole, as well as members?
This rule appears to make sense however its important that the interpretation of the
rule does not set the interests of creditors against members and vice versa.

3.2.2.4 Modified business judgement rule- the restructuring was
diligently pursued by the director?
This rule appears to make sense however there is no time limit and it will remain a
function of the restructuring plan as to what role the director will take. The director
should ensure the company diligently pursues the restructuring plan.

3.2.3 Summary of the case for a Modified Business
Judgement Rule ?
A case exists for the introduction of a modified business judgement rule as proposed
(and varied) under Option 2 of the Treasury Discussions Paper to create a “safe
harbour” in which to activate informal restructuring. Industry practitioners see such
a step as positive provided certain modifications are made to the rules.

17
Treasury Discussion Paper between the Law Council of Australia, the Insolvency
Practitioners Association of Australia and the Australian Chapter of the Turnaround
Management Association (“Joint Submission”)

16


3.3 Option 3 – the case for a Moratorium from the
insolvent trading laws?
This option would require a company to inform the market, including existing
creditors and potential new creditors that the company was insolvent and intended
to pursue an informal restructuring.

The concept is appropriate, particularly in the context of transparency with current
and future creditors, however for the following reasons, this option 3 is likely to fail
in the context of an informal restructuring. Publicly declaring insolvency:
1 is likely to trigger any number of the termination rights in the contracts the
company has with suppliers and customers. This would have the impact of
materially adversely impacting asset carrying values and the recoverability of
such values.
2 would impact a creditor that receives post announcement payments since the
receipt of such funds would expose them to claims by a liquidator that they
received an unfair preference.
3 would likely bring on the process of a formal restructuring rather than an
informal restructuring as substantial cash flow burdens would be brought to bear
on the company.
4 is likely to force all creditors to seek enforcement of their rights under contract.
Human behaviour being what it is will result in “every man for himself” rather
than “every man for the company”.

4 Other observations about the Treasury
Discussion Paper.
Whilst perhaps not the intention of authors of the Treasury Discussion Paper, there
was no attempt to resolve some of the difficulties around assessing insolvency. For
example, there is no attempt to simplify the meaning of insolvency or clarify issues

17


such as how far into the future a director must look in assessing a company's present
solvency.

There is a reluctance to seek to adopt the laws as they apply in other similar
common law jurisdictions. An inventing the wheel mentality has been adopted.

18


5 Bibliography
Texts
• Murray, Michael, Keay’s Insolvency: Personal and Corporate Law and Practice 6th
edition 2009
Legislation
• Corporations Act 2001
Publications
• Insolvency Works Pty Limited- Business Stress Report October 2009.
• Insolvent Trading: a Safe harbour for reorganisation attempts outside of external
administration January 2010, The Treasury (Treasury Discussion Paper)
• Law Council of Australia, the Insolvency Practitioners Association of Australia
and the Australian Chapter of the Turnaround Management Association (“Joint
Submission”) submission to Treasury Discussion Paper, 2 March 2010
• ASIC Consultation Paper 124: Duty to prevent insolvent trading: guide for
Directors. November 2009.
• Queensland University of Technology – Reading notes Semester 1 Insolvency
Law and Professional Practice.
• KPMG Restructuring Guidance notes: January 2010 Directors Decision Demise
Curve.
Cases
• Sandell v Porter (1966) 115 CLR, 666, 40 ALJR7
• Tourprint pty ltd (1999) 17 ACLC 1,543, [67]
• Manpac Industries P/L v Ceccattini (2002) 20 ACLC 1,304
• Byron v Southern Star Pty Ltd (1997) 15 ACLC 191.
• Stake Man Pty Ltd v Carroll [2009] FCA 1415
• Hall v Poolman [2007] NSWSC 1330
• Brady v Brady (1987) 3 BCC 535,552 (Nourse LJ)
Other
• Gonski, David Australian Securities Investments Commission Annual Policy Summit
Melbourne February 18 2008

19

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