COVID-19 – INSOLVENCY RELIEF – SAFE HARBOUR PROVISIONS
The Government, in response to the economic impact of the Covid-19 pandemic, has proposed legislative changes to the Companies Act 1993 (‘the Act”) with the intent of providing an exemption for directors to allow companies to trade whilst potentially insolvent.
Specifically a temporary safe harbour exemption will apply to relieve directors of their statutory duties and liability in respect of sections 135 and 136 of the Act.
Ordinarily, directors must not agree to:
- cause or allow the business of a company being carried on in a manner that is likely to create a substantial risk of serious loss to the company and creditors (section 135 of the Act).
- a company incurring an obligation unless the directors believe that at the time on reasonable grounds, the company will be able to perform the obligation when it is required to do so (section 136 of the Act).
The Covid-19 pandemic will have substantial effect on all businesses regardless of those that can continue trade during the period that isolation measures are in place. Once full business resumption is permitted, reconstituting cashflow will be challenging. Without cashflow, businesses will be squeezed to meet payment of their debts. The risk of insolvent trading is anticipated as businesses look to pick up the pieces after Covid-19.
While the risk of insolvent trading affects every business structure, whether it be sole traders, partnerships, trading trusts, or companies, the Government’s proposed legislative safe harbour exemption will only apply to companies. This reflects that the majority of businesses in New Zealand are operated under a company structure. Many companies have independent board members that may have no or little ownership interest but add value to the business. Such independent directors would most likely not be willing to expose themselves to personal liability for a breach of director duties should a company continue to trade whilst insolvent. The safe harbour exemption should help alleviate such concern for all directors.
Provided that a company will satisfy the safe harbour exemption criteria, the legislative amendments will provide a degree of tolerance to allow directors of companies some freedom to make decisions to:
- reconstitute the business of the company; and
- permit the company to assume new obligations within the next 6 months;
despite the fact the company may be insolvent.
The safe harbour exemption does not automatically apply. Directors must proactively consider and assess whether the company satisfies the criteria (as outlined below):
- In the opinion of the directors (acting in good faith), the company is facing or is likely to face a significant liquidity problem in the next six months as a result of the impact of the Covid-19 pandemic on the company or its creditors;
- The company was able to pay its debts as they fell due on 31 December 2019; and
- The directors (acting in good faith) consider it is more than likely than not that the company will be able to pay its debts as they fall due within 18 months (for example, because trading conditions are likely to improve).
If company was in an insolvent position prior to the Covid-19 pandemic, then the safe harbor exemption will not assist to relieve directors of their duties under sections 135 and 136 of the Act.
From a practical perspective, directors must analyse their company’s financial position as at 31 December 2019, and determine whether the company was able to pay its debts as they fell due in the ordinary course of business. This cannot be guess work. It will require at least the preparation of a retrospective statement of financial position taking into account the assets and liabilities of the company. Other factors such as unused bank facilities may be relevant to assessing whether the company was in a position to pay its debts provided the bank repayments were able to be met.
Directors in good faith shall also need to project forward the company’s business prospects to assess whether the company is able to pay its debts as they fall due within the next 18 months. This for some will be completely unknown, as many businesses will be reliant upon recoveries from debtors whose financial position may also be precarious. It would be imprudent for directors to consider that all debts will be paid when due by debtors. Directors will need to revise cashflows, budgets, review expenses and debtor recovery expectations together with opportunities and risks posed.
Directors should be considering and determining what other cost cutting measures or new business initiatives could be implemented to return the company to viability. It is not enough to rely on an assumption that the company will be able to pay its debts simply because it was viable prior to the Covid-19 pandemic.
The safe harbour exemption also factors in a contingency element so that if a company ultimately ends in an insolvency, directors may be exempted from liability if at the time of reconstituting business, the directors had reasonably determined the company would more than likely than not be able to pay its debt within 18 months, then the directors would still be relieved of their duties under section 135 and 136 of the Act.
Directors should be working with their financiers to ensure their continued support. Financiers should be asked whether the company can defer principal repayments or extend overdraft limits. Without such support, it is possible that companies may not be in a position to pay their debts in the long term.
Likewise with creditors, discussions should be had as to whether an informal compromise or staged payment plan can be agreed to, as this may assist with the road back to viability. However be aware that the company’s financier will be required to consent to any such arrangements as a financier could potentially deem entry into such arrangements with creditors a default event under financial facilities, entitling the financier to demand full repayment of its debt.
Directors need to evaluate and consider the financial impact of the Covid-19 epidemic on the business of the company. Directors should meet and engage with their professional advisers to set out and determine whether the safe harbour exemption criteria can be satisfied. The question of whether the directors acted reasonably in determining whether the safe harbor criteria are satisfied will be determined retrospectively by the Courts in each circumstance if challenged. Records of meetings, discussion and resolutions will be paramount in determining whether the safe harbour exemptions criteria were satisfied.
If directors’ reasoning in respect of the application of the safe harbor exemption criteria is found to be incorrect, the exemption from personal liability will not apply.
We can see the merit of the proposed amendments. However, there is also risk.
The safe harbour exemptions do not give any assurance to creditors of a company that company is in a position to pay its debts. In fact, if a company is unlikely to recover from the Covid-19 pandemic and continues to trade, the situation could worsen for all involved. Creditors or suppliers still need to be concerned as to whether their invoices will be paid.
The safe harbour exemptions do not extend to relieve directors of their duty of care under section 137 of the Act. Directors still must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstance.
If a company is unlikely to return to viability, directors may need to make the difficult decision to liquidate sooner rather than later in order to avoid worsening the position of the company’s creditors or exposing the directors to a claim for breach of the duty of care under section 137 of the Act, regardless of the safe harbour exemption.