Managing the Insolvency Curve in Australia

As with many countries trying to handle the current COVID-19 pandemic (on which see already this comparative analysis by Aurelio Gurrea-Martínez),  and as but one measure to limit the economic fall-out, the Australian government has made changes to the law to try to contain the large numbers of business and personal insolvencies that are expected to eventuate.

This has been done through the Coronavirus Economic Response Package Omnibus Act 2020 (Cth) which amends Australia’s two insolvency laws, the Bankruptcy Act 1966 (Cth), which applies to debtors who are natural persons, and the Corporations Act 2001 (Cth) (largely Chapter 5).  

The Omnibus Act amends the Bankruptcy Act to increase the threshold from A$5,000 to A$20,000 both for a bankruptcy notice being issued against a debtor, and for a creditor’s petition being presented to the court. If a bankruptcy notice is served, the time for a debtor to comply is increased from 21 days to a long 6 months. The Bankruptcy Act is further amended to allow for the stay period that a debtor can obtain against creditor recovery action through a ‘declaration of intention to present a debtor’s petition’ (s 54A of the Act as amended by the Omnibus Act) to be increased from 21 days to 6 months. The law contemplates that these six-month time periods may need to be further extended.

Parallel changes are made to the Corporations Act to increase the minimum debt threshold to commence liquidation proceedings by way of a ‘winding up demand’ from A$2,000 to A$20,000 and to increase the time for a company to respond to a demand from 21 days to six months, again with an option to extend this period.

There is always extensive pre-insolvency use by creditors of bankruptcy notices and winding up demands as means of debt recovery without leading to a formal insolvency order.  Those debt recovery mechanisms are now so restricted by the six-month period for compliance as to be of little value for creditors seeking to secure payment.

The extent to which these reforms will serve to limit the number of perhaps ‘unnecessary’ insolvencies is unclear.  This is because other triggers for liquidation will remain available to creditors, along with other debt recovery mechanisms. How, or whether, a creditor would want to use them in the current crisis is another matter. Additionally, those insolvency matters pending at the day before this new law commenced—24 March 2020—can still proceed, though the insolvency courts do retain a general discretion to refuse a creditor’s application for a winding up or a sequestration order in particular cases.

In any event, creditor-initiated insolvencies comprise only 10% of bankruptcies in Australia, and around 23% of corporate insolvencies.  The real impact of COVID-19, not touched by the reforms, may be in relation to voluntary insolvencies entered by debtor companies or individuals seeking protection of the insolvency laws.

Voluntary liquidation and bankruptcy

These voluntary insolvencies remain available without any additional restrictions and they will inevitably increase in number. Issues regarding the capacity of the Australian insolvency system to handle that increase are discussed in our joint article: Managing the insolvency curve – a new government role is needed? 31 March 2020 issued through Murrays Legal and through Australian Insolvency Law.

The Australian government’s A$130 billion relief package and other measures will secure the continuation of many businesses that would otherwise have folded and retention of their employees, for the moment. To what extent that may only defer the problem, and also maintain otherwise unviable businesses, remains to be seen.

Given not only the state of the Australian economy but also that of its international trading partners, the overall outcome is necessarily difficult to predict. That uncertainty has motivated the inclusion of a general power for the Australian Treasurer to exempt or modify certain provisions in the Corporations Act as they apply to classes of persons (s 1362A of the Act as amended by the Omnibus Act). At the time of writing, industry associations are lobbying the government for a raft of exemptions and modifications all framed within the mantra of saving businesses during the pandemic.

The ‘suspension’ of insolvent trading liability

A more controversial change in Australia is to in effect ‘suspend’ the laws imposing liability on directors for insolvent trading under s 588G of the Corporations Act by way of new s 588GAAA - Safe harbour—temporary relief in response to the coronavirus. Holding company liability is similarly suspended: s 588WA.

Section 588G - Director's duty to prevent insolvent trading by company has always been seen as imposing a strict duty on directors and a potential for their personal liability, although it was tempered in 2017 by the introduction of a ‘safe harbour’ regime (s 588GA - Safe harbour—taking course of action reasonably likely to lead to a better outcome for the company). That gives directors protection from liability if their attempts to address their company’s problems meet certain statutory requirements.

That law remains in force but s 588GAAA now offers a similar safe harbour protection but only for debts that are incurred by the company in the ordinary course of its business in trying to meet the financial stresses of the pandemic.  According to the Supplementary Explanatory Memorandum to the Omnibus Bill 2020 (at [12.18]), these are debts incurred as being necessary to facilitate the continuation of the business during the six-month period during which the section operates. Examples are given of debts incurred in financing on-line operations of a business and financing the continued retention of employees. That is in fact narrower in scope than the existing safe harbour protection under s 588GA for debts incurred.

The crunch would come in relation to either safe harbour provision when, if the company fails despite the safe harbour endeavours, a liquidator later reviews the conduct of the directors in terms of whether they adequately secured their safe harbour protection.

Any criminal or other abuse of the system will come under close scrutiny and the new law preserves the operation of such liability. Other more general duties owed by directors under the Corporations Act, such as those of care and diligence and good faith (cf sections 180 and 181 of the Act), have not been changed by these new laws.

Reaction to the changes

The safe harbour changes have had a mixed reception, being seen as favourable to the larger enterprises, rather than the smaller small to medium enterprises, and as being adverse to creditors generally.

Creditor groups’ responses may be to try to better protect their position through tighter trading terms and taking greater security (where possible). The impact of reduced access to credit may then have negative consequences. 

Personal liabilities and bankruptcy

It should be mentioned that no concession has been given to the law in Australia that a person remains in bankruptcy for a minimum of three years.  An earlier bill to reduce the period to one year, as in the UK, did not proceed, after opposition to the change. 

The significance of that is that in SME business insolvencies in Australia, and in many countries, there are inevitably both company and personal liabilities, many of the latter often arising from company debts being personally guaranteed.  The restrictions of bankruptcy lasting well beyond the hoped for end of the pandemic this year may have unfortunate extended economic consequences. It may also be a reason for many who find themselves unexpectedly insolvent as a result of the pandemic to try to avoid bankruptcy or to pursue alternatives available under the Bankruptcy Act.

The benefit of cross-jurisdiction comparisons

Other jurisdictions are taking similar courses to that in Australia, each depending on its particular insolvency laws, as well as the United Kingdom, although its moratorium and restructuring plan would go further than Australia’s laws at present.  These are being pursed in recognition of the importance of insolvency laws in supporting governments’ economic, social and financial measures.  It is important that we each monitor the impact of these insolvency changes in providing that suppor.    

Michael Murray is an Australian insolvency and reconstruction law author and commentator at Murrays Legal.

Jason Harris is Professor of Corporate Law at the University of Sidney.