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Directors' duties - Insolvent trading: Five rules to deal with a company in financial difficulty

John Stragalinos

John Stragalinos
John Stragalinos
Many sectors of the Australian economy are experiencing tough economic conditions including retail, manufacturing, agriculture, automotive, mining, mining services and construction. 

What is a director’s duty when he or she is faced with a company in financial difficulty and how should boards deal with such a situation?

Directors in Australia face onerous duties if their company faces financial difficulties.  At the forefront is a director’s positive duty to prevent a company from trading whilst insolvent.  Directors must prevent their company from incurring debts where the company is insolvent, or becomes insolvent by incurring the debt(s) and at that time, there are reasonable grounds for suspecting the company is insolvent, or would become insolvent.

Failing to guard against insolvent trading may result in the director being personally liable for payment of compensation, a pecuniary penalty order and/or disqualification from managing a corporation.

A company is deemed insolvent when it cannot pay its debts as and when they fall due.  While the test is simply stated it involves a range of accounting and legal issues.  When determining a company’s solvency a Court will consider the overall financial circumstances as a matter of commercial reality.  And while the Courts place particular emphasis on a cash flow test, they will also consider a range of balance sheet factors including the realisation value of assets and the ability to raise further funds, be it equity or debt.

So if a company is in financial difficulty, what should directors do?

FIVE GOLDEN RULES

Directors should apply five golden rules:

1. First and foremost, directors must avoid “a head in the sand” mentality as the problem is unlikely to go away without action.  The board should be proactive and act early and quickly.

2. Directors should increase their monitoring of the financial position of the company if it is facing financial difficulty.  In particular, directors should adopt more vigorous safeguards including increased monitoring of the company’s bank facilities, its cash flow, current assets and current liabilities.  They should also be alert to danger signs such as continuous losses, poor liquidity ratios, overdue taxes or trade creditors and an inability to produce timely and accurate financial information.

3. The board should seek legal and financial advice and develop a “Plan B”.  Directors of companies often rely upon the injection of fresh funds from an asset sale or a capital raising to emerge from financial difficulties.  But what if that transaction was to fail or be delayed?  Is there a Plan B?  Can debts be paid in the meantime?  Boards should seek legal advice on their duties and restructuring advice from a restructuring and turnaround professional. 

4. Banks hate surprises!  Engage with your bank and other financiers sooner rather than later, whether you are the size of Centro or a small manufacturer in Geelong.  Banks in Australia have been very supportive of companies since the GFC and they are more likely to support a borrower that is proactive and engages with its bankers/ financiers.  If the banks have confidence in you and your advisers, you can expect that they will constructively engage with you and do their best to assist you through a restructure and turnaround, regardless of the size of your business.

5. It takes time.  Restructures and turnarounds can take time to prepare and implement.  They can be very complex and require the input of many stakeholders, especially for large companies. Some may require a formal scheme of arrangement that will take several months to implement.

In recent years there has been a marked increased in work undertaken by restructuring and turnaround professionals in Australia drawing upon experiences from the UK and USA.

A turnaround / restructure plan can take many forms but often includes the following key aspects:

A review of the financial position of the company and its solvency.

A review of management structures, financial systems and key personnel.

A review of bank facilities and other debt.

A review of cash flow and working capital and options to improve working capital.

An operational turnaround which will include a review of trading performance and implementation of measures to improve financial and operational performance.

A consideration of options to raise additional funds, for instance, equity or debt raising, or the disposal of assets. Other options may include a conversion of debt to equity.

Negotiations with key stakeholders including lenders, employees, unions, major creditors, landlords, major customers and shareholders.

Many turnarounds and restructures are completed on a consensual and confidential basis and gain little, if any, publicity. Others may require formal restructures through schemes of arrangement supervised by the Courts (for example:  Nine Entertainment, Alinta and Centro).

Finally, as a last resort, a formal appointment of an Administrator and/or Receiver may be required to restructure and save a business (for instance: Darrell Lea, Colorado Retail Group, St Hilliers Construction, Lane Cove Tunnel and Clive Peters).

In short, taking early action to restructure and turnaround the business can dramatically increase the chances of trading out of financial difficulty. It also reduces the risk that a director may be held liable for insolvent trading.

THE NEED FOR LAW REFORM

Unfortunately, Australia’s onerous insolvent trading laws and lack of protection against ipso facto clauses can make some restructures and workouts more difficult. In broad terms, an ipso facto clause allows a contracting party to terminate a contract due to an insolvency event, or an appointment of an external administrator to a counter party.  This can cause major operational disruption to a company at a time when it needs to stabilise. Protection against ipso facto clauses is a key feature of the US Chapter 11 Bankruptcy regime. If the new Federal government is as business friendly as it claims, it should recognise the need for law reform in this area and reconsider adopting a business judgment rule in the area of insolvent trading. And possibly some form of protection against ipso facto clauses, but that may be a bridge too far!


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