Trading while insolvent liability and forbearance and restructuring agreements in Australia
March 2015 | SPECIAL REPORT: GLOBAL RESTRUCTURING & INSOLVENCY
Financier Worldwide Magazine
While there are certainly defensible policy reasons for holding directors liable for trading while insolvent, such liability presents an additional complexity to a successful restructuring. This is particularly true when a company has accessed the US debt markets. As a preliminary matter, unlike directors in Australia, directors of US companies are not subject to trading while insolvent liability. US creditors, therefore, may be unfamiliar with the concept and not sensitive to the dynamic it creates in a restructuring scenario involving an Australian issuer or borrower. Additionally, in the context of bank debt or US private note debt, addressing director concerns may be manageable given both the number of institutions involved and the mechanics for forbearances under the relevant document. The same is not always true for public bond debt. Distressed companies with public debt typically face engagement with a greater number of holders, a more formal process for consents and waivers and holders’ concerns about possessing material non-public information.
In many countries, the directors of a company may be liable to the company’s shareholders or a regulatory body for, among other things, negligent actions that worsen the company’s financial condition. In Australia, directors may be liable for incurring debts while the company is insolvent or for incurring debt that renders the company insolvent, regardless of whether a reasonable person might have made such a decision in his or her business judgment. Incurring debt, as defined in section 588G of the Corporations Act (Cth), generally includes not only the incurrence of more traditional debt but also the incurrence of debts such as payroll, taxes and vendor obligations. The Corporations Act imposes a duty on directors to prevent the incurrence of debt where the director is aware that there are grounds for suspecting the company is insolvent or a reasonable person in the same circumstances would be so aware. Moreover, section 588G imposes criminal liability where, in addition to the factors listed above, the director’s failure to prevent the company from incurring the debt was dishonest.
The Corporations Act defines insolvency based on the cash flow test, and, therefore, a company is insolvent when it is unable to pay its debts as and when they become due and payable. However, such cash flow test is tempered by the willingness of creditors to forbear on exercising remedies following a default.
Section 588H provides certain defences available to directors for trading while insolvent, including, notably, the appointment of an administrator. However, unlike a US bankruptcy, there is no debtor in possession in Australia. Once the directors appoint the third party administrator, they hand over the keys, often permanently, and secured creditors with a charge over the company’s assets are then entitled to take possession of their collateral by appointing a receiver. Premature appointment of an administrator could be value destructive if it forecloses a realistic opportunity for an out-of-court consensual restructuring.
Importance of forbearance arrangements
One means for a director to obtain comfort in determining solvency following an event of default under its debt documents is for the company to enter into forbearance arrangements with the relevant creditors, be they banks and/or noteholders. This provides an opportunity for the company to restructure what might otherwise be current debt obligations.
Typical bank and note documents require only a majority, be it a simple or super majority, in order to waive most covenant defaults. Defaults in the payment of interest or principal, however, generally require the consent of all holders. Negotiating forbearance in connection with bank debt or private placement notes involves the standard obstacle of consensus building among the group in order to achieve the requisite forbearance threshold. Many factors influence an investor’s decision to forbear or take enforcement action, including market conditions, portfolio constraints, the purchase price (par vs. distressed), whether the debt is secured, the value of any collateral and the underlying investment goals of individual investors. In bank and private note debt arrangements, all interested lender parties are identifiable and can be brought, if willing, to the negotiating table to document forbearance arrangements directly with the borrower.
In the case of public noteholder debt, the task is even more challenging, more expensive and usually requires more lead time. As a preliminary matter, public note debt is often more widely held than bank or private note debt. Therefore, merely finding holders with the requisite threshold of notes may require significant diligence. Second, a company will often require holders to sign a confidentiality agreement before discussing sensitive financial information in connection with a forbearance request. However, public noteholders are frequently reluctant to become restricted from trading their debt by obtaining material non-public information about the company. In practice this leads to a bifurcated forbearance discussion – a smaller subset of noteholders elects to obtain non-public information to provide feedback to the company’s request and later, if the restricted noteholders agree on the terms of the forbearance, the details of the proposed forbearance are disclosed publicly in an attempt to obtain requisite noteholder consent. Finally, public notes are governed by an indenture between the issuer-company and the indenture trustee. Amendments to the indenture typically require a formal consent process through the Depository Trust Company (DTC) whereby the request to direct the indenture trustee to take certain action is delivered to all holders. A formal forbearance on exercising remedies following a payment default requires a similar process in order to provide the issuer comfort that the percentage of notes required to accelerate the note obligations (25 percent, for example) cannot organise and force the company into administration. Given director liability concerns, as well as the indenture trustee’s desire for clear direction, directors may have little choice but to opt for the formal DTC process after negotiating a forbearance support agreement with a subset of holders. These multi-step processes take time and energy away from the limited resources of the issuer-company that could otherwise be spent improving the business and negotiating the ultimate restructuring solution.
Understandably, most borrowers fail to consider the restructuring challenges specific to different sources of debt when accessing the capital markets, and making capital structure decisions. However, borrowers would be well advised to consider the implications of their debt structure in a downside scenario, especially when faced with a potential default scenario. The likelihood of an Australian company successfully implementing a restructuring increases dramatically if it proactively approaches its creditors with sufficient lead time to complete the necessary multi-stop process required to negotiate a forbearance or amendment.
Separately, it would be beneficial in promoting restructurings over liquidations, for Australia to consider adopting safe harbour provisions to help insulate directors from liability if they are pursuing restructuring discussions with the company’s key creditor constituencies. In January 2010, the Australian government published a paper on the subject of director liability and invited comments in considering legislative action to provide a safe harbour to directors engaged in informal work-outs outside of administration. While various organisations expressed their support for the adoption of such measures such as a safe harbour, not all agreed on the form that the safe harbour provisions should take and, ultimately, the efforts have stalled without resulting in legislative change.
It is important for US creditors to be aware that directors in certain foreign jurisdictions may face personal liability for their actions when a company nears insolvency, or becomes insolvent. In Australia particularly, where directors face civil liability for incurring debt when a company is insolvent, creditors and borrowers alike must be prepared to engage in restructuring or refinancing discussions early enough to avoid a precipitous fall into administration. In most cases, creditors should view an appropriate forbearance arrangement not as a weakness in their position, but as a means to preserve recovery value.
Renée Dailey is a partner and David Lawton is an associate at Bracewell & Giuliani. Ms Dailey can be contacted on +1 (860) 256 8531 or by email: firstname.lastname@example.org. Mr Lawton can be contacted on +1 (860) 256 8544 or by email: email@example.com.
© Financier Worldwide
Renée Dailey and David Lawton
Bracewell & Giuliani