Dominic Emmett and Hannah Cooper, Gilbert + Tobin
The Australian federal government, like many governments across the globe, has enacted temporary legislative changes to provide relief for businesses that have been impacted by the economic effects of the covid-19 pandemic. In order to facilitate continued business operations, the changes provide companies with breathing space to respond to demands from creditors for overdue debts and protect company directors from insolvent trading claims for debts incurred during the covid-19 period.
This relief took effect from 25 March 2020 and, as at the date of writing, will expire on 25 September 2020. In July 2020, the Australian government suggested that the measures should be extended beyond September 2020 with the Treasurer, Josh Frydenberg, stating, “the regulatory shield that provided changes to insolvency and bankruptcy laws has prevented a potential wave of failures and bought time for businesses to get through the crisis”.
This article considers the effects of this “regulatory shield” and whether it should be extended beyond the current expiration date. While the relief initially offered an appropriate response to an emergency event, the covid-19 pandemic has proven to be more than just a short-term problem. It is clear that Australia requires a longer-term solution to address the impact of the crisis and, perhaps at the same time, also implement broader legislative reform of Australia’s insolvency laws. This article argues that extending the regulatory shield against the ordinary operation of Australia’s insolvency laws will merely prolong the corporate failure of already distressed businesses and will likely result in a tidal wave of companies entering insolvency at the moment the regulatory shield expires.
On 23 March 2020, the Australian federal government introduced the Coronavirus Economic Response Package Omnibus Act 2020 (Economic Response Act), with the objective of providing temporary relief for financially distressed businesses and promoting business continuity in the current climate. The Economic Response Act was passed by the Houses of Parliament on 23 March 2020 and its provisions came into effect on 25 March 2020. It seeks to provide a safety net for businesses in financial difficulty so that they can remain operational and resume normal activity once the threat of covid-19 subsides.
The Economic Response Act provides a regulatory shield against the operation of the existing insolvency laws in three principal ways.
First, the Economic Response Act raised the threshold at which creditors can issue a statutory demand and also increased the time companies have to respond to a statutory demand. Ordinarily, the threshold is A$2,000 and if companies do not respond to a creditor’s statutory demand within 21 days, that creditor can seek to wind up the debtor company. Under the temporary covid-19 measures, the threshold for issuing a statutory demand has been increased to A$20,000 and companies now have six months to respond.
Secondly, company directors will largely be immune from insolvent trading claims. Insolvent trading is a serious threat to directors in Australia, and often directors will pre-emptively enter into voluntary administration in order to avoid this risk. Under the temporary covid-19 measures, directors will not be liable for debts incurred while the company is insolvent provided that the debt was incurred in the “ordinary course of business”. The ordinary course of business requirement has not been tested in a court of law, but is likely to include acts such as the taking out of a loan to move certain operations online or to continue to pay employees.
Thirdly, the Economic Response Act allows the Treasurer to provide targeted relief for classes of persons from their statutory obligations, and is intended to enable companies to deal with unforeseen events resulting from the covid-19 pandemic. Ordinarily, a company would have the option of issuing a request to the corporate regulator for relief from failure to fulfil or comply with its statutory obligations; however, this can be a time-consuming and drawn out process. Examples of the exercise of this power include permitting company directors to electronically execute documents and to hold annual general meetings online.
Since the covid-19 pandemic began, quite counter-intuitively, there has been a decline in the number of companies entering insolvency and insolvency practitioners have observed a decrease in insolvency and restructuring work. For the period from July 2018 to June 2019, the Australian corporate regulator reported 7,182 insolvencies, which is consistent with the general average of around 8,000 insolvencies per year. However, that figure decreased by 12 per cent for the period from June 2019 to July 2020 and the number of insolvencies reported for July 2020 is half that of July 2019.
This trend can be contrasted with countries around the globe where governments have chosen to address corporate failure during the covid-19 pandemic by introducing fiscal rescue packages for businesses, rather than altering the operation of corporate insolvency laws. Countries where such measures have been implemented include the USA, China, Sweden and Ireland, and the types of fiscal relief offered include bailouts for distressed companies, greater small business protection, direct payments to taxpayers, expansion of unemployment benefits such as wage subsidies, and credit support from financial institutions. Despite the billions of dollars spent by governments in providing this relief, however, these countries are already reporting a surge in corporate insolvency filings with further projected increases for 2021. For example, the USA is expected to record a 57 per cent increase in insolvencies for 2021 as compared to 2019, and in China there was a 143 per cent year-on-year increase in formal insolvency filings for the month of April 2020.
While the decline in corporate insolvency filings in Australia is attributable to the regulatory shield enacted by the government, this decline is likely obscuring a tidal wave of insolvencies that will emerge when the shield is removed. Since around June 2020, Australian commentators and practitioners have raised genuine concerns about the effects of the government’s relief measures. The Australian Restructuring Insolvency and Turnaround Association (ARITA), the peak body representing Australian insolvency practitioners, has estimated that at least 20 per cent of Australian businesses are trading while insolvent during the covid-19 pandemic period. Ordinarily, there are serious monetary and criminal penalties imposed on directors who trade while their business is insolvent. As such, directors are motivated to pursue voluntary administration or informal workouts if they consider the business is at risk of insolvency.
In July 2020, the Australian corporate regulator revealed that it was preparing for a tidal wave of business collapses after September 2020. ARITA has also warned of the increasing risk that the government’s relief measures are allowing non-viable businesses to slip through the cracks. The effect of the relief measures is that these “zombie” businesses are continuing to trade, and so incurring debt to their customers and suppliers, because the directors are effectively immune from being held personally liable. This is problematic given the customers and suppliers of such businesses are unlikely to ever be repaid because the business’s profitability is entirely dependent on governmental fiscal support. Reliance on the relief measures, rather than pursuing a restructuring or entering liquidation, has the effect of shifting the risk of corporate failures onto creditors. In the case of small and medium-sized businesses, those creditors are themselves small suppliers and sole traders, who are vulnerable and have little chance of recovering if their owed debts remain unpaid.
Further, other insolvency laws – such as the liquidator’s power to claw back certain payments made by companies in the six months leading up to their collapse – remain in place. The Turnaround Management Association (TMA), a body dedicated to turnaround management and corporate renewal, has raised the concern that these clawback laws will be especially harmful to the suppliers of small and medium-sized businesses that have supported companies trading through the covid-19 pandemic. This is because these suppliers may be required to disgorge any unfair preference payments back to the company’s liquidator.
The economic effects of the covid-19 pandemic have been felt globally and Australia’s regulatory shield against the insolvency laws is not unusual on the international stage.
Many countries, particularly in Europe, have extended the time to repay debts owed, enacted a moratorium on creditor enforcement of debts or suspended the obligation on companies and directors to file for insolvency. Singapore has introduced relief for companies unable to fulfil contractual obligations under specified contracts due to the covid-19 pandemic. This relief also includes temporary adjustments to monetary thresholds and time limits for corporate insolvency.
In the United Kingdom, the government was already considering a broader reform of insolvency laws and the covid-19 pandemic meant that those changes, alongside temporary measures to specifically address the covid-19 pandemic, were expedited through Parliament and came into effect in June 2020. The temporary measures included a suspension on insolvent trading laws. The rationale for these temporary reforms is similar to that in Australia, being to facilitate continued trading through the covid-19 pandemic without the risk of personal liability for directors in the event of insolvency.
Closer to home, New Zealand, like Australia, has introduced temporary laws that provide directors with a safe harbour from insolvent trading claims and halt the payment of debts with the aim of preserving liquidity. In order to rely on the relief for repayment of debts, the debtor is required, first, to prove it was solvent before the covid-19 pandemic and, second to actively engage with its creditors to come to an alternative repayment proposal. In contrast, Australia’s automatic increase of the statutory demand threshold from A$2,000 to A$20,000 prejudices creditors, and the new six-month time limit to respond to statutory demands means that debtor businesses can kick the can down the road until the relief is lifted on 25 September 2020.
In a cabinet paper supporting the changes, New Zealand’s Minister of Commerce and Consumer Affairs remarked that the relief introduced in Australia would be inappropriate for New Zealand and would create practical difficulties at the end of the temporary period. The Minister raised some serious concerns with the Australian approach, including that the transition back to the lower threshold for issuing a statutory demand will be difficult and that it would be unusual for a company that has been trading while insolvent to be immediately solvent again once the temporary changes are lifted. Further, the Minister observed that a six-month period to respond to demands would “effectively place the statutory demand system in hiatus because there would be no point in issuing them”.
Evidently, governments are attempting to manage the economic and public health consequences of the covid-19 pandemic in various ways. Governments have sought to prevent unnecessary insolvencies by introducing temporary changes to their insolvency laws to give distressed businesses required breathing space. However, it is important to remember that these changes were initially only intended to provide an emergency response for a limited period of time.
As we move further away from the initial covid-19 outbreak, it is becoming increasingly clear that the pandemic and its consequences are not temporary and that governments will need to act to address the ongoing economic uncertainty and impending tidal wave of insolvencies that will inevitably arise in the months and years to come. Australia, like much of the world, is looking at a period of deepening economic distress. According to figures released by the Australian Bureau of Statistics, Australia formally entered recession in the first three months of 2020. Covid-19 together with the bushfire disaster (and other natural disasters) that occured in the past year have resulted in drastically reduced government and household spending and a reduction in imports, foreshadowing a very challenging period ahead for the Australian economy.
In acknowledging that the government relief addressing the economic impact of the covid-19 pandemic cannot continue indefinitely, the Australian government has been considering ways in which to wean businesses off the financial relief handed out to date – although the nature of those measures has not yet been disclosed. Although the government has extended some economic relief measures to March 2021, such as wage subsidies for employees, it is still debating whether it would be appropriate to extend the operation of the regulatory shield on insolvency laws beyond September 2020. The government has said: “We do not want to perpetuate zombie firms. We don’t want to threaten the viability of creditors and small businesses. But at the same time we want to provide the flexibility to restructure during a once in a century pandemic.”
While the TMA has publicly supported extending the regulatory shield, it has acknowledged the risk that further extensions may have unintended consequences, such as the perpetuation of zombie companies and the stranding of capital that could be otherwise deployed for new investment and the creation of jobs. An extension is also, unsurprisingly, supported by the Australian Institute of Company Directors.
However, insolvency practitioners are more wary. Global perspectives reveal that, while temporary changes to insolvency laws may have been beneficial initially, there comes a point when the benefits of the temporary changes become a crutch for failed businesses to prolong their inevitable demise. ARITA has described the temporary measures as a “behavioural handbrake” that, unless re-engaged, risks businesses large and small falling deeper into insolvency in a way where there is no possibility of turning their businesses around.
It is expected that the insolvency market will be significantly challenged in the coming months and years once the regulatory shield is lifted and there is a rise in the number of insolvencies. There has been a downward trend in the number of registered liquidators in recent years, presumably due to the general decline in insolvency work over the past decade. In addition, redundancies were experienced across the profession following implementation of the regulatory shield, which severely reduced the availability of work. As such, there is a palpable fear that the sector may lack the capacity to respond to a significant increase in insolvencies, particularly large and complex appointments.
Regardless of whether the government decides to extend the regulatory shield from the ordinary operation of Australia’s insolvency laws, Australia is bracing for a tidal wave of corporate failures in the near future. This article has highlighted that an extension of the regulatory shield will only worsen the effect of that tidal wave.
In order to manage the anticipated increase in corporate failures and companies entering into formal insolvency processes, the Australian government should be considering practical steps to assist insolvency practitioners to manage this increased workload. ARITA has recommended providing extensions to and flexibility around statutory reporting and notification requirements for insolvency practitioners. Further, a recent inquiry into the insolvency of small and medium-sized businesses recommended that a bespoke liquidation process should be developed for such businesses to make the process simpler and more accessible.