‘Safe harbour’ protections may help Australian startups and scaleups ride out the current storm

The duty to prevent insolvent trading arises if an Australian company incurs a debt at a time when:

• the company is insolvent or would become insolvent by incurring the debt; and
• there are reasonable grounds for suspecting that the company is insolvent or would become insolvent by incurring the debt.

If director is aware, or a reasonable person in the director’s position would be aware, that such grounds exist, the director is required to prevent the company from incurring the debt. In practical terms this may require the director to appoint administrators if there is no other pathway forward.

A holding company can also be liable for insolvent trading by its subsidiaries.

Here a ‘debt’ includes any liability to pay an amount in the future and is not limited to bank debt or other finance debt. It includes, for example, incurring liabilities to pay for goods and services (eg amounts owed to trade creditors and lease payments), tax liabilities and liabilities to staff for wages and entitlements. It also includes raising funds through loans (whether with related parties or third-party financiers) and through debt securities such as redeemable preference shares, convertible notes and Simple Agreements for Future Equity (SAFEs), even if they are only repayable in limited situations (unless they are only repayable at the company’s option). Some transactions that are typically thought of as capital-like transactions are considered incurring a ‘debt’ for these purposes such as paying a dividend and certain share redemptions, buy-backs and capital reductions.

Companies incur liabilities in day-to-day operations. So, if a company is already insolvent, a breach of this duty can arise if the company continues to trade. For this reason, it’s typically described as a duty to prevent insolvent trading.

The Australian Corporations Act has a specific definition of “insolvent”. Under that definition, an Australian company is insolvent if it is unable to pay all of its debts as and when they become due and payable.

A company can be insolvent even though its debts have not yet fallen due for payment. Insolvency arises at the point where there is sufficient likelihood that the company will not be able to meet its debts when they become due, not at the time when those debts actually fall due. It therefore requires consideration of the future, not merely the present.

The test for insolvency is a cash flow test, not a balance sheet test, but is not based solely on the immediate cash resources of the company. When considering its solvency, a company can include funds that it can, on a real and reasoned view, raise by the sale of assets, raising capital, secured borrowing or other reasonable means within the time period required to meet debts as they fall due.

If a company that has a known remaining “cash runway” but a real and reasoned expectation of raising capital before the end of that runway, its directors may therefore be comfortable that it is not insolvent under the above test. But it will be important to continue to monitor and test that position as time passes and circumstances potentially change.

Directors should also consider, if for any reason funds are not able to be raised when expected, what evidence they would point towards to demonstrate that the capital raising was nevertheless a realistic and reasonable expectation at that time.

Directors who breach this duty are at risk of civil penalty orders, including a fine of up to $1,110,000 or, if the Court can determine it, three times the amount of the benefit derived and detriment avoided because of the contravention (whichever is the greater). They are also at risk of orders to compensate the company and/or its creditors, including liability for unsecured debts incurred after the date it becomes insolvent and that remain unpaid in a liquidation. Compensation is calculated by reference to the relevant creditors’ losses; in other words, the directors may be required to cover the outstanding debts personally.

For more serious breaches (where directors have acted dishonestly), criminal penalties may also apply.

Directors may be at heightened risk of disqualification by the Australian Securities and Investments Commission from acting a director of other companies where they are found to have engaged in insolvent trading.

Under the safe harbour exception, the duty to prevent insolvent trading does not apply if:

• at a particular time after the director starts to suspect the company may become or be insolvent, the director starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator; and
• the debt is incurred directly or indirectly in connection with any such course of action during the period starting after that time, and ending at the earliest of any of the following:
  • if the person fails to take a course of action within a reasonable period after that time – the end of that period;
  • when the person stops taking any such course of action;
  • when the course of action ceases to be reasonably likely to lead to a better outcome; and
  • the appointment of an administrator or liquidator.

Accordingly, safe harbour protection is available any time after the directors begin to suspect that a company is or may become insolvent. To obtain that protection the directors must ‘start developing’ a safe harbour plan being one or more courses of action which are reasonably likely to result in a better outcome – an outcome that is better for the company than the immediate appointment of the administrator or liquidator. Once a course of action is selected it protects the directors from liability for debts incurred for as long as the directors are continuing to pursue that course of action and it continues to be reasonably likely to result in a better outcome.

There are a number of specific factors that a court may have regard to when considering whether a course of action was reasonably likely to lead to a better outcome. These factors are whether the director:

• is properly informing himself or herself of the company’s financial position;
• is taking appropriate steps to prevent misconduct in the organisation that could adversely affect the company’s ability to pay all its debts;
• is taking appropriate steps to ensure the company is keeping appropriate financial records consistent with the size and nature of the company;
• is obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice; and
• is developing or implementing a plan for restructuring the company to improve its financial position.

However, the safe harbour protection is not available if the company is failing to pay employee entitlements when due or to comply with certain tax filing obligations (certain minor failures excepted).

Directors have an “evidentiary burden” if they wish to rely on the safe harbour. This means that directors have an initial burden of pointing to evidence that suggests a reasonable possibility that the requisite requirements of safe harbour are satisfied. It is therefore important to keep detailed records of compliance with the safe harbour requirements.

More generally, there is some complexity to the operation of the safe harbour exception. Directors who wish who to take the benefit of this exception should therefore seek specific advice on the application of the exception in preparing their safe harbour plan.

Finally, it is important to note that whilst the safe harbour exception protects directors from civil liability (including compensation claims), it does not provide protection from criminal liability should directors act dishonestly.

In addition to (or as an alternative to) the safe harbour exception, directors also have a defence to insolvent trading liability if they can prove that, at the time that the debt was incurred, the director had reasonable grounds to expect, and did expect, that the company was solvent and would remain solvent even if it incurred the debt. This expectation of solvency requires a higher degree of certainty than ‘mere hope or possibility’ or ‘suspecting’. The defence requires an actual expectation and confidence that a company is and will continue to be solvent and that the grounds for so suspecting are reasonable. Ignorance of the company’s financial position is not a defence.

Directors may also have a defence if:

• the director did not take part in management of the company for some good reason (eg illness) when the debt was incurred; or
• the director had reasonable grounds to believe (and did believe) that a “competent and reliable person” was responsible for providing to the director adequate financial information about whether the company was solvent, that person was fulfilling that responsibility, and the director expected on the basis of that information that the company was and would remain solvent (a defence that is generally more relevant for directors of larger companies who are more reliant on management reporting to the board).