Viewpoint
Australian businesses enjoyed a period of sustained economic growth that provided boards with many choices on how to resolve financial problems. It is very easy to restructure a business when asset values are rising. The challenge is somewhat greater when there is economic uncertainty.
AICD and PPB recently hosted a discussion that focused on the choices directors have when the going gets tough, given their liabilities for trading while insolvent. The Minister for Corporate Law, Chris Bowen, has since announced a package of reforms to Australia’s corporate insolvency laws, including steps to amend the Corporations Act to reverse the effect of the High Court’s decision in Sons of Gwalia v Margaretic.
An edited version of the discussion follows:
Steve Burrell: Insolvency is a very topical issue at the moment. The Australian Securities and Investments Commission (ASIC) recently released a discussion paper on it and a Senate inquiry will look into some aspects of the insolvency industry, as will the Parliamentary Joint Committee on Corporations and Financial Services. Insolvency is certainly in the news and very much top of mind for directors in the wake of the global financial crisis (GFC). Today we’d like to consider whether the current state of insolvency law in Australia is adequate, whether any changes are needed and what the appropriate balance is between good corporate governance and ensuring directors are able to, and willing to, take sensible commercial risks. What are the pros and cons of the current legislation for trading while insolvent and, indeed, is the current model broken?
David Gonski: If one goes back in history, the insolvent trading legislation was created as a trade-off for limited liability. The concept was that you give limited liability to the company, but still ensure the directors keep an eye on the balance sheet and pay the debts when they fall due. My contention is that, at least for some companies, that trade-off is finished. For those companies large enough to be subject to the continuous disclosure rules, the concept of having an insolvency provision that revolves around someone trying to make a decision, which they can only truly assess after it has happened, is outdated. The creditors can definitely make that decision themselves. The obvious disadvantage of the legislation – and that’s why it was in there – was to ensure directors were not reckless and that they looked after the balance sheet and the assets of the company, and that they didn’t take advantage of the limited liability status. A disadvantage that has developed over a period is that it makes directors incredibly nervous. I am sure there are many cases where directors have called in the administrators fairly quickly and you can’t say they were right or wrong. They had to look after themselves as well as other stakeholders. Perhaps because of their fear, directors are closing down the company earlier than it needs to be. And, we all know that as soon as there is an administrator, some companies have lost their business, which is definitely the case in financial services.
A second “con” is that the legislation has an effect on the ability to get people as directors. I don’t know how many of us would go into a small company as a director. Some may disagree, but I would think twice about going on the board of a company that didn’t have a very good balance sheet because of the insolvency provisions. It’s a question of personal liability. It’s not just about reputation, as it could be argued that a reputation may be fine if you go into a terrible company and you do no better than anyone else. But if you happen to be there when it becomes insolvent, you will have many problems. My contention is that the legislation was probably a correct thing once upon a time but has outlived its usefulness, particularly in relation to companies subject to continuous disclosure or companies with enormous operations that directors just couldn’t know all about.
Burrell: Obviously one of the key issues for directors is the question of deciding when a company is trading while insolvent. How grey is the line here and how great is the challenge this creates?
Anthony Shepherd: If you are a director of a company having chronic cash-flow difficulties, you would really be challenged to remain in that position if this was an ongoing problem. I have been in that position and I bailed because, frankly, it was too risky from a personal point of view... You sit there as a director of a public company on $40,000 to $50,000 a year and ask: “Is this worth the risk?” Obviously not! So the tendency is to leave a company with these pressures, especially in a listed company environment, where the potential for people taking action against you is immensely wider than in a private company.
Rosalind Dubs: I guess the issue has been judged complex enough for the director community for ASIC to issue that recent draft regulatory guide. Certain journalists have opined that this is overkill – that it should be a simple question. But I think a rigorous assessment of a financial position does take experience and it also takes time. It’s not clear whether you should be looking three months out or 12 months, but the important thing is that you do need to ask your own questions. I agree that it is a grey area and I think it has become more difficult recently too because of a new risk, the reduced liquidity in the market.
Ian Hutchinson: When I heard about what we would discuss today, I went back and re-read Hall & Ors v Poolman & Ors, and I think there are a few lines from Justice Palmer that really say it all. The law recognises there is sometimes no clear dividing line between solvency and insolvency from the perspective of the directors of a company in difficulties... Sometimes it takes quite a lot of time to work liquidity issues out and the law simply doesn’t allow for it.
Penny Morris: I was involved on the board of a troubled company… I had to step in and take the chair because there were conflicts of interests and I was really the only appropriate person that could have done that. We had no choice but to put the company into voluntary administration and it was ugly… I guess one of the most important lessons you can learn from that is to really have a very good gut feeling about how robust you think the finances are and that you are getting an accurate picture.
Gonski: Insolvency becomes a personal issue… You became chairman just at the point I would be leaving the room. Insolvency is a bit like a recession or depression. You only know officially that you’ve been in a recession or depression afterwards because the statistician tells you that you have.
Stephen Parbery: The psychology is really interesting. It is a very personal decision and we see different decisions made at the big end of town compared with the bottom end of town... I ask myself why a director would sit there and continue to take responsibility. People often lose sight of what personal exposure they are really facing at that point, usually people of profile too, and you question if they really know what might happen here and to their reputations as well… You have to look at it from the point of view of the aggrieved, what they might say about you. They have faith in you as a director to look after their interests.
John Colvin: I had a great grandfather who started Uncle Toby’s Oats and he used to have various rules for investments. One was that you look at the directors first. Second, you have another look at the directors and then third, you ask: “Will these directors fight for me right to the last dollar?” After making that assessment, you then have a look at the industry and whatever else the company does. But you started with the directors and if you did not get anywhere there, you would not invest. What happens now is that the insolvency laws have made it the exact opposite. At the first sign of smoke, the rational approach of a director under current laws is to bail instead of looking after the company, the investors, shareholders and employees. I recently went to a briefing attended by leading liquidator lawyers and they confirmed that Australia was at the extreme in this area in terms of directors’ liability. We know it has a negative effect on attracting and retaining top-level directors. We need some deep thinking about this law and to ensure you have a proper business judgement rule attached to it. I have asked a couple of directors why they stayed when a company got into trouble and they said they thought it was the right thing to do. They have since been reputationally damaged in the press and may face court action. It should also be remembered that there are more than 660 state laws making directors liable.
Parbery: I am in favour of modifying the law, but you get the extreme the other way too. You get the directors who think they are doing their best by continuing on – and often they are not. They are inexperienced in dealing with the issues at that point. They are actually doing damage to the creditors by continuing to do what they think is the right thing for shareholders… So I think there needs to be a balance by allowing a business judgement rule as a possible defence for insolvent trading. At the bottom end of town, in small private companies, people also abuse the insolvent trading law. You can advise them that if they continue to trade and incur credit, they will become personally liable. But they will say they had to hock the family home and are broke anyway.
Shepherd: Well, then you really do need to protect the creditors.
Gonski: It has to be a two-tiered thing then?
Parbery: That’s my idea. But how do you deal with that? It might be limited only to public companies of a certain capitalisation.
Gonski: I have a theory that may be wrong, but I think if you are subject to continuous disclosure, which means you are listed, that’s an easy deliberation. Because if you are coming up for a repayment or you don’t have the money, you’ve got to tell everyone. But I don’t know what you do with a wealthy public company that’s not listed.
Dubs: If you look at the discussion paper ASIC put out and the questions it is asking in testing whether directors of a company have breached their duties, I think it’s clear that it would have expected a higher standard of due diligence to have been exercised by the more prominent boards of larger companies than it would for smaller ones. So I think there’s a natural differentiation in the standard of performance of directors. But certainly continuous disclosure is a mechanism that could be used for larger listed companies.
Gonski: I read the ASIC paper and I disagree with it. If you look at the history, this legislation was put in place when companies were formed by merchants who generally lived and worked in the same premises they were seeking limited liability for. When you take a very big company, it may have operations all over the world and have liabilities, such as occupational health and safety, in many countries. So, the idea of more important boards is nullified because of the complexity of those companies.
Colvin: There’s another issue here too. This isn’t about whether the law is good or not, or whether you’ve done the right or the wrong thing. It’s about the regulators giving their view on how the law might be.
Parbery: There is a point to be made here about the law itself. There have been very few court cases run on insolvent trading. Part of the reason is that at the time of bringing in the insolvency law, they brought in voluntary administration. So not only could you put your hand up early, you could actually agree with your creditors to avoid any claims for insolvent trading through a deed of company arrangement. Despite such an agreement, ASIC still has the right to pursue directors for insolvent trading as was the case with John Elliot in theWater Wheelmatter. At times, the current insolvency laws are driving behaviour in a way that may not be conducive to a work-out, especially in the more complex matters we are working on. Practitioners are often reticent to get involved because we might be deemed to be shadow directors. The banks are also loath to get involved because they may be deemed shadow directors and caught up in this law. You cannot underestimate what problems it is causing in behaviour. Some banks like it because they like directors to try a bit harder. But I think the law needs to be modified. We are out of step with the rest of the globe.
Shepherd: This gets down to the role of directors – what a director is required to do. Directors’ responsibilities in North America are quite different to here. I can speak to a director of a public company in America and ask what he is doing about this and he’d say: “I wouldn’t really interfere at that level in this business. That’s an operational issue.” They might have eight board meetings a year and a different attitude altogether to the role of directors. This law in Australia is another example of how directors just seem to be getting loaded up.
Colvin: We noted at the beginning that there’s a trade- off for limited liability. I think we’ve got to the stage where that trade-off is not there. There are more than 660 state laws giving directors liability and every time something goes wrong they create another liability. They often just leapfrog what is already there.
Burrell:Perhaps we should move on to options for reform. What changes should be made?
Parbery: I don’t think the voluntary administration process is all that bad. In fact, it’s been very effective, so it’s not the regime itself that’s the problem. What leads to whether you are deemed to be insolvent is the issue. The debate is about what is an acceptable level of risk that creditors should take, as opposed to companies.
I think that in terms of reform itself, the biggest thing we could change in Australia is the Sons of Gwalia issue in dealing with shareholder rights. I just find it quite bizarre that if you get to an insolvent position, we have a system that works two ways. One, we have litigation lenders who fund disgruntled shareholders who haven’t had proper disclosure and effectively become creditors of the company at the expense of its ordinary trade creditors. That needs immediate reform. It doesn’t happen in the US. If you become insolvent there, shareholder rights are relegated below those of creditors. Our laws are fairly similar to the UK’s, which are akin to a consumer law that allows you to sue, but they don’t have litigation lenders and no one there is going to fund the shareholders. We have this odd set of circumstances where we have similar law to UK law but also allow the funding of litigation. That causes huge problems. This area needs reform. There are a number of examples I am aware of where banks have been reticent to put together a rescue package to save a business before a formal insolvency appointment because of contingent shareholder claims that cannot be quantified. Therefore, the key parties capable of attempting to save a business are discouraged because of the law as confirmed in the Sons of Gwalia decision.
Gonski: What if banks were only to lend with security? In the past, you could never borrow from a bank without giving some form of security. In the last few years, it has become more commonplace to lend unsecured. If loans remain secured, the Sons of Gwalia decision isn’t a problem. So the banks can solve it themselves but perhaps not after an insolvent event.
Directors have to act with diligence and honesty. I don’t understand why that doesn’t cover the concept of reckless indifference to the shareholders and the company generally. You can come back to whether there should be a safe harbour, but if you accept that sections 180 and 181 of the Corporations Act are correct, why do we need the insolvency law at all? My argument would be that solvency is not really a separate issue any more. Taking a reckless approach to the continuation of your business and to the ability of the banks to get their money are breaches of the fundamental duties of directors. One question is who is going to take the action against directors. Quite often with big companies, the shareholders will take the action, whereas little companies are run by Joe Blow and he’s not going to take action against himself.
Shepherd: That would be the only flaw in it, but generally speaking, continuous disclosure should deal with it. It’s onerous and does have the business judgement rule and other things in it.
Gonski: I would suggest governments start dealing with this issue by looking in the not-for-profit (NFP) sector. There are people sitting on bowling club boards who don’t realise the dangers of insolvent trading… You have to do it in the right way because we don’t want people to give up on the NFP sector. So what you have to do is change the law quickly and efficiently to protect the NFP sector. You can do that by extending the safe harbour provisions or you can do that by getting rid of the provisions on insolvency for NFPs. But then the question is: “Why don’t you do it for the lot?”
Morris: That’s a good strategy because a major problem is that we are also dealing with the perception around directors, that they earn too much money, have soft and cushy lives, and should be weighted down legislatively as much as possible. People have different views about NFPs – those good people out there doing charity without being paid – and we need to protect them.
Parbery: Again there’s need for balance because I have seen a lot of NFPs that don’t have very good corporate governance. With some modification, the insolvency laws can work because you have to encourage directors to put up their hands early if you wish to safeguard creditors and have a chance of a turnaround. If you combine the current insolvency laws, but allow NFP directors the benefit of the business judgement rule as a defence to insolvent trading, that would give some relief to that sector. However, without the insolvent trading laws, in my view, section 180 of the Corporations Act is not sufficient to force directors to take the bitter pill and therefore this can be very detrimental to the position of creditors.
Colvin: AICD’s position is that there should be a proper business judgement rule extended to the section to allow for a proper defence for directors. Another debate is whether we should restructure these laws to have an Australian version of Chapter 11?
Parbery: The problems with Chapter 11 are that you are handing back the keys to the Christopher Skase’s of the world to solve their own problems. It is fundamentally flawed. This would have to change. Chapter 11 is also driven out of the courts and it is very costly.
Burrell:To summarise, clearly Sons of Gwalia is a big issue we need to address and I know AICD’s law committee has a task force dealing with this. I think there is a general consensus here that the business judgement rule should be expanded to questions of insolvency and with particular focus on NFPs. There is also the possibility of extending safe harbour there or getting rid of provisions of insolvency in general for them. There’s potentially an idea of an opt-in system where you could have a two-tiered arrangement for larger and smaller companies, probably on a listed and non-listed basis. But this would have to be thought through in detail – and the devil is in the detail.
Moderator
Steve Burrell
General Manager, Communications & Public Affairs, AICD
Participants
John H C Colvin FAICD
CEO of AICD. Chairman of Can Assist
Dr Rosalind Dubs FAICD
Director of Aristocrat Leisure. Chairman of the Australian Government’s Space Industry Innovation Council
David Gonski AC FAICDLife
Chairman of Investec Bank (Australia), ASX and Coca-Cola Amatil. Director of the Westfield Group and Singapore Airlines
Ian Hutchinson FAICD
Director of Australand Holdings. Chairman of Hoya Lens Australia. Consultant to Freehills
Penny Morris AM FAICD
Director of Mirvac, Aristocrat Leisure, Clarius Group and Bowel Cancer Australia
Stephen Parbery FAICD
Founding partner of PPB
Anthony Shepherd MAICD
Chairman of Connecteast and Transfield Services. Director of Transfield Services Infrastructure Fund and the Australian Chamber Orchestra