Businesses at risk offered safe harbour
The Government rushed a bill through last month to help companies at risk of trading insolvently because of Covid-19. Previously directors were liable if they traded recklessly. Bell Gully partner Tim Fitzgerald and senior associate Sarah Leslie explain the changes to Mark Jennings.
What is the situation now?
Directors have been dealing with challenges nobody could have predicted only a few months ago. The sudden shut-down left many businesses short of cash, and potentially unable to pay their debts when due. Directors in that position need to take a serious look at whether they can continue trading. They risk breaching several legal duties, including duties not to trade recklessly (trading unprofitably in a way that reduces the assets available for claims and creates a serious risk of loss to creditors), and not to incur obligations without a reasonable belief they will be paid when due.
The concern in the Covid-19 environment was directors would feel obliged to close otherwise profitable businesses, even if those businesses would be profitable again after the crisis. That would have led to job losses, unpaid creditors, and a substantially smaller economy once the crisis passed.
The new rules address that risk by providing a ‘safe harbour’ for directors whose companies were able to pay their debts before the onset of Covid-19, and are expected to be solvent after the impact of the pandemic has passed. But certain criteria must be met. The business must be facing significant liquidity problems directly as a result of Covid-19 – the safe-harbour won’t apply to directors whose businesses would have been in this position anyway. Directors must also believe, in good faith, it is more likely than not they will be solvent and able to pay their debts when due, by September 30 next year. They might expect to reach a compromise with their creditors, for instance, or believe trading conditions for their business will improve.
The changes seek to give directors comfort they can continue to trade through these uniquely difficult conditions and preserve their businesses, where they might otherwise be required to close.
Are directors getting off the hook here?
No – at least not entirely. The Government incorporated mechanisms to protect the position of creditors to the extent consistent with the purpose of the safe-harbour rules. The changes aren’t a free-pass: directors must continue to consider whether ongoing trading is in the best interests of the company (including its creditors) if the company is nearing insolvency. They should also continue to assess whether the company will be able to pay its debts after September 30 next year.
Creditors can enforce their debts in the usual way, subject to the new Business Debt Hibernation scheme (or any other insolvency process), and the changes have no effect on the criminal provisions that can apply for serious breaches or insolvency breaches of directors' duties.
Significantly, the changes are also time-limited. They only apply during the Covid-19 crisis. There has not been a philosophical revisiting of directors' duties: this is relief, not reform.
Directors might be acting in good faith now but what happens if things get worse for their company within the six-month period?
Directors need to continue to believe that it’s in the best interests of their company to continue to trade. As long as they meet the entry criteria for the regime – that their business was solvent at the end of 2019 and will continue to be solvent after September 2021 – that’s likely to be the case. But if circumstances change, and directors no longer believe that they’ll be solvent afterwards, then there would be serious questions about whether they are continuing to act in the best interests of the company.
The regime also allows creditors to require directors to ‘recertify’ those elements. So if creditors have any concerns about whether the criteria continue to apply, then they can make directors certify that they do.
The bill is introducing a debt hibernation scheme. What is this designed to do?
The debt hibernation scheme allows a company to reach out to its creditors and strike a deal to effectively ‘pause’ the enforcement of debts against that company.
The scheme recognises that none of the existing restructuring regimes in the Companies Act 1993 are intended to preserve the status quo of a company, as opposed to restructure the company or realise its assets. This new regime works in tandem with the safe harbour provisions to allow directors to weather the storm.
When can a business use the hibernation scheme?
Again it boils down to whether directors can establish the company had no prior solvency issues as at December 31 last year (or was formed between January 1 and March 25), think any significant liquidity issues they face in the next six months are the result of the effects of Covid-19, and consider it is more likely than not the company will be solvent by September 30 next year.
Hibernation is a new addition to several debt management options. It offers a month of protection from the enforcement of debts from the date the proposal is notified to the Registrar of Companies, then six months protection if the proposal is approved by creditors. If directors don’t think a company’s problems will be resolved in that time-frame, this probably isn’t the right solution.
Overall, directors need to make a realistic assessment of their position, then act promptly and engage early with creditors. In our experience so far, many businesses have been able to maintain good relationships with their stakeholders and negotiate the support needed to see them outlast the Covid-19 crisis.
Is this fair to creditors who might also be struggling with their own liquidity?
It’s true the regime could mean creditors might not be able to recover perfectly legitimate debts on time, but with some protections like recertification, the scope of the scheme is also limited. Debts can be postponed, but not compromised. Any interest owed will continue to accrue. Creditors can refuse to continue to supply a business if they think that the terms of the hibernation proposal don’t offer enough protection.
For hibernation to extend beyond the initial month, more than half of creditors (by number and value) need to vote to allow the additional six months’ moratorium. Creditors should engage with a business as soon as possible after receiving initial notice of hibernation, to negotiate the inclusion in the voting proposal of specific events to end hibernation.
What protections do creditors have if they think a company might be getting into deeper trouble during the hibernation period?
As mentioned, they can require directors to recertify, but they would be better served by agreeing in advance what will trigger the end of hibernation.
The scheme doesn’t apply to debts assumed after it was adopted. If a company puts itself into business debt hibernation then places another order, it still has to pay.
Secured creditors who hold a general security agreement – normally banks – are able to enforce their security despite a debt hibernation proposal. Such creditors have the ability to call in receivers. Other creditors may take some comfort if a bank has not done that - if they do, that ends the hibernation. So would liquidation, voluntary administration and a creditors’ compromise.
Isn’t there a risk with the Business Debt Hibernation scheme that new creditors would shy away from being involved with these companies?
The legislation tries to avoid that in two ways. Debts incurred after the company enters hibernation aren’t covered, and there’s specific protection from the voidable transactions regime for people trading with a company in debt hibernation. Ordinarily, liquidators can claw back payments made to creditors shortly before a company went into liquidation, if the creditors knew it was unable to pay. As that would pose a challenge for anybody trading with a company in hibernation, that liquidation regime won’t apply to companies in hibernation.
Knowing a company is only in the regime if directors believe it will be solvent again may also offer new creditors comfort.
If you are a director of a company hit by Covid-19 but are worried that you can’t meet the good faith requirements of the new bill are there other alternatives to continue the business?
Yes, there are a range of other restructuring regimes. If directors believe a company can’t pay its debts when due, but the core business of the company is salvageable, they can appoint a voluntary administrator. That imposes a moratorium on all debt collection, while the voluntary administrator takes control of the company and considers whether it can be saved through a restructuring proposal to creditors or shareholders.
The advantage of voluntary administration is it can provide for a compromise or restructuring around debt. Business debt hibernation only lets you push pause – voluntary administration might mean you agree to pay 75 percent of your debt and the other 25 percent goes away.
Similarly, directors can propose a compromise with creditors under Part 14 of the Companies Act. That will bind all creditors if 50 percent (by number) and 75 percent (by value) of each affected creditor class give their approval. That’s a powerful tool which keeps control with directors, but it doesn’t include a moratorium – so anyone can enforce their debts until the compromise is passed. With business debt hibernation or voluntary administration you do get a moratorium on enforcement.
There are also options around schemes of arrangements to implement complex restructurings with shareholders (enforced by the courts), or even straightforward private arrangements with creditors. Companies need to consider their particular circumstances: each option will suit some businesses but not others.
Do you think the complexity of the regime may limit its uptake among small to medium-sized enterprises?
That is a concern. The regime was simplified during the drafting process to try to make it more accessible, but there is a higher level of legal detail than some may like. MBIE has produced some user-friendly guidance to assist anybody who needs help.
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