Commercial Law
Companies Act changes

Some Initial Reflections

On 3 April 2020, Minister of Finance Grant Robertson announced a slate of proposed changes to the Companies Act 1993 (the Act) to protect companies affected by the Covid-19 related Lockdown (the Lockdown). These proposals, which will be the subject of new legislation to be passed once Parliament resumes sitting, are aimed at loosening procedural restrictions and providing companies who were previously successful better opportunities to trade out.

The two most significant proposed changes in the new package are the introduction two new provisions to deal with companies that experience liquidity difficulties in the months immediately following the lockdown.  The first is a so-called “safe harbour” provision that will protect directors from claims of reckless trading if they attempt to trade out of liquidity issues following the Lockdown.  The second is a new “business debt hibernation” scheme proposed as an alternative for liquidation, to permit companies to continue trading through this period with the support of their creditors.

Importantly, both new provisions only address solvency in terms of liquidity. They provide protection for companies that have cashflow difficulties and are unable to pay their debts when they fall due for a short period. For companies that accumulate new debt during the Lockdown and enter balance sheet insolvency, there are no additional protections. Also significantly, while both provisions encourage directors to trade out of difficulty, they require the cooperation of a company’s creditors to operate. Neither provision provides protection for creditors, making it likely that creditors will take a sceptical approach to companies trying to rely on the Governments inducement to trade out.

Directors Duties Generally
The Act places four main duties on directors of companies: to act in good faith and in the best interests of the company (s 131); to act for a proper purpose (s 133); not to trade recklessly (s 135); and not to assume obligations unreasonably (s136).

The key duties in terms of the recent proposal are the duties relating to reckless trading, which are focused on an objective standard of what a reasonable director would do. While courts are generally prepared to defer to the commercial judgment of a director in assessing these duties, the director must have acted reasonably and exercised proper judgment. Relying on expert advice can assist in proving that a decision was a reasonable one in some cases.

The most common situation where claims for breaching these duties arise is where a company has traded while insolvent.  Where this happens, courts have regularly required directors to reimburse the company for losses that occurs after the date the Court considers that the company ought to have been liquidated. In some cases, the court may also impose damages for loss where the director failed to take a course of action that could have saved or prevented the loss that didn’t occur.

Particularly where the company is either insolvent or nearly insolvent (whether in a balance sheet or cashflow sense) the director must apply sober judgment in deciding whether it can continue to trade. Both duties apply this same standard, with the difference being that one focuses on the overall course of trading (s135) and the other is aimed at individual (usually large) transactions the director agrees to assume (s136).

Because of this, directors who consider trading out of trouble often expose themselves to significant risk. They are required to exercise caution in deciding whether to continue trading, and risk being required to personally pay for any loss suffered if the court subsequently determines they were wrong to do so. As such, this regime is a barrier to many companies considering to attempt such a course

The Safe Harbour Provision
The Safe Harbour provision is intended to reduce the disincentive for directors deciding to trade out. It operates to protect directors from claims under ss135 and 136 on the basis that the company was unable to pay its debts when they fell due (a liquidity crisis) where three key criteria are met:

  • the director must believe in good faith that the company will face a liquidity crisis in the next six months due to Covid-19;
  • the company must have been able to pay its debts when they fell due on 31 December 2019; and
  • the director must believe in good faith that it will be able to trade out and pay its debts as they fall due within 18 months (whether by compromising with creditors or improving its trading performance).

While the current material available does not specify how the safe harbour will apply, it is likely it will be treated as a defence to claims under as 135 and 136 or an exception to those sections.

In practice, what this proposed amendment does is introduces a subjective standard into s 135 and 136 of the Act.  If the language used by the Ministry of Finance in its release is to be believed, the applicable standard will now be whether a director believes in good faith that it will be able to trade out – as opposed to the present standard of whether it is reasonable.

It is unclear how the courts will approach this change.  In our view, there are two main possibilities.  First, the courts may adopt the good faith approach that currently applies under s131 and 133.  Alternatively, the courts may seek to soften the language of good faith by adding a requirement that the director believes “on reasonable grounds” that the company could trade out – resulting in a test almost identical to that which applies at present.

If they take the former approach, then this will have the effect of removing the objective standard of reasonableness for the time being.  This is a severe reversal from the present requirement that directors faced with a liquidity crisis apply “sober judgment” in assessing whether to continue trading, or whether the life of the company is at an end.  While it would make it easier for companies to keep trading, it would do so by placing creditors at greater risk.  This kind of change could make creditors more hesitant to let companies keep trading (since they know they will not recover any losses they suffer from the directors) and may have the unintended effect of making creditors more likely to push for liquidation.

On the other hand, if the Court applies an objective standard then little will change.  As it stands, directors are able to attempt to trade out when companies are insolvent, provided they act reasonably.  This strikes a balance between the interests of creditors, who are entitled to protection from unwillingly funding companies to take risks with their funds and the need for directors to be able to take commercial risks.  It is likely that this kind of approach will continue.

In our view, the most likely outcome of this reform is that courts will continue to apply an objective standard to reckless trading that closely resembles the standard in use currently.  The Act has now been in place for more than 25 years, and over that time, the courts have developed an extensive jurisprudence around the concepts of reasonableness and legitimate and illegitimate business risks.  While courts will almost certainly accept that directors of otherwise solvent companies are likely to have a reasonable basis for trading out, it will always depend on the circumstances.  Unfortunately, those who most need assistance to survive – those in industries that are affected more than usual by the Covid-19 response and those who were already near the line in terms of solvency – will receive less leeway when the inevitable occurs.

Business Debt Hibernation
The Safe Harbour provision is only effective if the company is able to continue trading. As such, the Government has recognised the need for a way to prevent creditors from using a liquidity crisis to simply force a company into liquidation. This is where the second major reform - Business Debt Hibernation (BDH) - comes in to play.

BDH allows companies that are experiencing a liquidity crisis to seek approval from their creditors to “park” debts for a period of six months while they attempt to trade out of difficulty.  Where this occurs, no creditors will be able to enforce their debts during this time and new debts would not be subject to the voidable transaction regime – meaning suppliers would not be tempted to cease supply in order to avoid being forced to repay money if the company ultimately failed. 

BSH will not be available to all companies.  The criteria for applying have not yet been released.  As with the Safe Harbour provision, these criteria will likely depend on whether the company appears well placed to trade out of trouble.  If the company qualifies, it may make a BDH proposal to its creditors, and if half of them (both in terms of individual creditors and total debt owed) agree, then the BDH protections would apply for a period of six months.  Companies would be able to buy themselves the protection of the scheme (referred to in the release as a “moratorium”) for one month simply by making the initial proposal.
In the absence of clear criteria for when BDH will be available, it is difficult to analyse its likely impact or scope.  However, some initial points of concern can be identified.  First, the provision depends on the consent of creditors to implement.  These creditors, who will also be suffering the effects of the Covid-19 response, will likely be hesitant to agree to stand at the back of the queue for six months to allow a company to attempt to continue trading.  As such, many creditors will simply reject the possibility of BDH in any but the clearest cases.

It is worth noting that even without BDH, liquidation by creditors is far from immediate.  The usual process can take several months, without the introduction of the BDH scheme.  Those creditors who agree to a BDH moratorium may ultimately face a delay in enforcement of nine months or more.  The impact of such a long delay on creditor’s recovery could be severe.
The prohibition on enforcement must also be viewed in context.  Not every process that creditors use to require repayment are court-directed.  It is just as effective for many creditors to refuse supply until debts are paid.  Given that continued trading will be essential to a business succeeding at trading out, those creditors who are able to turn off the tap of supply will still be able to see their debts paid, while others will not be able to expect payment until the moratorium period ends.  This is very likely to lead to unequal treatment of creditors in practice.

Balance Sheet Issues
A further challenge common to bon proposals is that they only address a liquidity crisis and provide no protection for those companies who, following the Lockdown, find themselves in a position of balance-sheet insolvency.  This is problematic, because the impact of the Lockdown will unquestionably impact on the balance sheets of many companies.  Most companies are faced with continued outgoings in the face of reduced or stopped revenues.  A balance sheet decline is almost inevitable, and this will be compounded in the case of those companies that need to rely on the Business Finance Guarantee programme to survive.

Addressing balance sheet issues is more challenging than dealing with a liquidity crisis, but it is by no means impossible.  Through a return to productivity and careful financial management over the next 12 to 24 months, even companies that are insolvent in a balance sheet sense may return to financial health.  In our view, more targeted relief may be required to address this part of the equation, which is currently missing.

The failure to address balance sheet insolvency will not be immediately obvious, but it may prove fatal to the effectiveness of the new provisions in the long run.  While it is liquidity that normally triggers involuntary insolvency, the protection provided by the Safe Harbour provision, in particular, will not apply to a company that is experiencing both balance sheet and cash flow insolvency.  As the impact of the Lockdown on the value of assets, especially intangible assets, will be difficult to assess for some time, companies may also not be able to determine yet whether they have crossed into balance sheet insolvency with the risks that entails.  This is important, as courts will often accept that a company was insolvent even at a point in time when the directors were unaware of it – introducing risks for those who continue to trade, even on the boundaries of insolvency.

The provisions that the Government has promised to introduce are intended to help mitigate the worst impact of the Lockdown on businesses, by providing them with an opportunity to trade out.  However, it is simply impossible to mothball an entire economy for a month (or longer if the Lockdown is extended or other alert restrictions applied) and moving the goalposts on a well-established set of protections for creditors will not be able to undo the impact that the Lockdown will have on many businesses.

While the Government has correctly identified one of the major challenges that businesses will face, in terms of diminished cashflow, the proposed cure leaves many gaps and uncertainty.  Without greater work being done, it is our view that the impact of these new provisions is likely to be relatively limited.  The reality is that for most businesses that survive this period, it will be the ability of their directors to manage cashflow, to communicate effectively with creditors and to work creatively, that will ensure they are able to continue trading.  Care and proper advice during this period will be key.

For directors, the most important question for the next six months will be whether they can continue trading.  The decision whether or not to trade out is always a difficult one and requires a careful and sober judgment.  In our experience, it is a decision that directors ought not to make alone.  Accountants, lawyers and insolvency professionals are invaluable to directors faced with determining whether a company can continue trading.  In our view, and despite the Government’s attempt to lower the bar to trading out, now is the time when companies will most need the assistance of their professional advisors in deciding whether to attempt it.

For creditors, it will be important that they keep an eye on their debtors.  Where a company is able to trade out successfully, this will be in the best interests of creditors as well.  But there are risks in enabling a company to continue trading, and it can result in creditors returns being diminished.  As much as it is important for directors to communicate with their creditors, creditors can protect themselves to a greater degree if they are actively engaging with companies that owe them money from an early stage.  While some businesses will be wary at first of open conversations with their creditors, the only way that these new provisions (especially BDH) can work is if creditors have a seat at the table when considering what the future of a company may look like.

Fundamentally, our advice to all clients considering these issues is to keep an open door – both to business partners and to expert advisers.  Holland Beckett Law has experience advising in all of these areas, and works collaboratively with a number of insolvency practitioners, with whom it can provide tailored advice for companies and directors considering what their post-Lockdown future will be.

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