Guide to insolvency law changes during COVID-19
The Government has announced substantial changes to the Companies Act 1993 (Companies Act), which are designed to support businesses struggling as a result of the impact of COVID-19 and the Level 4 Government-imposed lockdown.
The aim of these changes is to preserve business and to help companies avoid insolvency during this turbulent period and for a six-month period thereafter, thereby reducing the long-term impact on our economy. The emphasis is very much on providing a comprehensive framework to assist companies that are acting reasonably and prudently, but are otherwise encountering difficulties as a direct result of COVID-19.
What temporary changes have been announced to prevent insolvency?
The Government has announced two key legislative changes to the Companies Act designed to prevent solvent businesses facing temporary financial distress from being prematurely placed into liquidation.
The two key insolvency regimes announced by the Government include the:
- ‘Business Debt Hibernation’ (BDH) regime, which provides businesses with an option to place existing debts on hold until they can start trading normally again, subject to creditor agreement;
- ‘Safe Harbour’ regime, which provides directors with security against a legal claim for failing to meet their insolvency duties under the Companies Act as a direct result of the impact of the COVID-19 pandemic.
These changes are intended to assist by providing directors with the assurance needed to continue to trade, despite the risks of insolvency due to decreased cashflow. Similar regimes have already been implemented to help preserve solvent businesses in Australia and the United Kingdom.
Both regimes are subject to legislation being passed in Parliament over the coming weeks, and once passed will apply retrospectively from 3 April 2020.
Business Debt Hibernation
The BDH regime provides a simple and flexible method for businesses to negotiate an arrangement with their creditors to place the payment of existing debts on hold until they can resume trading as usual. This is similar to the Creditors Compromise scheme under Part 14 of the Companies Act, which allows a company to implement an arrangement with some or all of its creditors.
The process of the BDH regime is expected to operate as follows:
- The affected business notifies its creditors that it intends to put forward a BDH proposal, subject to meeting the threshold required (the details of which have yet to be announced).
- The creditors have a month to vote on the proposal from the date of notification. The creditors are prevented from taking legal action against the company to recover their debt during this month.
- If 50 percent of the company’s creditors (calculated by number and value) agree to the company’s existing debt being “hibernated” under the proposal, it becomes binding on all creditors. In this instance:
- The creditors are prevented from taking legal action against the company to recover their debt for a period of six months.
- The business in BDH continues to trade and to pay new third-party creditors. The payments made to third-party creditors will not be subject to the voidable transactions regime if they meet certain requirements.
- If the proposal is rejected by the creditors, the directors have the option of either continuing to trade, entering into a voluntary administration, or appointing a liquidator.
The BDH regime is designed to open the lines of communication between debtor and creditors and enable directors to retain control of the company, rather than passing control to an insolvency practitioner upon liquidation. It will also provide certainty to new creditors that they won’t have to repay any money they receive if the business is subsequently placed into liquidation. This in turn will encourage businesses to continue transacting with companies who are in BDH by limiting their risks in doing so.
The scope and application of the proposed BDH regime at this early stage is unclear, including how it will operate practically, how quickly it will come into force, and whether creditors will engage with the scheme to enable it to succeed. If COVID-19 restrictions extend beyond 4 weeks, creditors may be unable to agree to existing debt being “hibernated” due to the flow on effect this will have on their own cashflow.
Other significant issues that have yet to be clarified within the BDH regime include:
- Whether the “existing debt” to which the BDH applies must have arisen as a result of COVID-19, or if it can relate to prior debt.
- If a debtor can reasonably “prioritise” some creditors over others, with those others having their debts deferred for 6 months.
- Whether commercial rent can be deferred under the scheme, and the effect this has on the cancellation provisions in a Deed of Lease.
We will continue to monitor these issues and provide updates when further details on the regime are made available.
Safe Harbour regime
The impact of COVID-19 creates an unprecedented amount of challenges for company directors. A key issue is how to trade through this period of significant uncertainty without breaching their duties under the Companies Act, including the duty not to trade while insolvent. There are serious consequences for breaching these duties, including potential personal liability for reckless trading (section 135) or incurring an obligation the directors did not believe the company would be able to meet (section 136).
The Safe Harbour regime will temporarily protect directors from personal liability under section 135 and 136 of the Companies Act for a period of 6 months, effective from 3 April 2020. It is designed to assist directors who are managing companies facing significant liquidity issues by limiting their risk and easing their concerns in doing so. This is intended to encourage directors to continue to trade and incur obligations, as opposed to prematurely winding up the company due to the risk of personal liability.
For the Safe Harbour regime to apply to directors’ decisions, three key requirements must be met:
- In the good faith opinion of the directors, the company is facing or is likely to face significant liquidity problems in the next 6 months as a result of the impact of the impact of the COVID-19 pandemic on them or their creditors;
- The company was able to pay its debts as they fell due on 31 December 2019; and
- The directors consider, in good faith, that it is more likely than not that the company will be able to pay its debts as they fall due within 18 months.
It is important to note that the regime does not relieve directors from their duty to act in good faith and in the best interests its creditors, nor does it protect directors of businesses that were not solvent prior to COVID-19. While the scheme provides directors with an opportunity to trade through this period of uncertainty, they are still required to ensure that they are taking legitimate business risks relative to the current economic climate. If there is no prospect of recovery, directors will still be required to assess whether entering into voluntary liquidation or administration may be necessary to protect creditors.
Disclaimer: The content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose. While we make every effort to ensure the accuracy of the information contained in this article, this is a rapidly changing environment and the information will be subject to change.