Are directors and holding companies liable for their Australian subsidiary's debts - what is "COVID-new" and what hasn't changed?

The Australian Government has made some temporary changes to director and holding company liability during the COVID-19 period. Though the relief is welcomed by business owners, the changes may serve to worsen current solvency issues and encourage directors to take unwise risks. To be prepared, directors should seek advice, maintain records and monitor their Australian businesses closely during this time. See our advice at the end of this article for more.

Trying times and director duties

Many ordinarily solvent businesses may soon, if not already, be insolvent as cash flow issues prevent them from paying their debts on time. Directors of Australian companies would generally be cautious about approving the taking on of further debt at such a time because, to do so, may put directors at risk of being personally liable for such further debts arising as a result of insolvent trading.

Personal liability can be imposed where the director was aware or ought to have been aware of an Australian company's insolvency, and the company is subsequently wound-up: Corporations Act 2001, s588G(2).

Recognising the difficulties directors face in trying to navigate their company through this universally difficult (but hopefully temporary) economic time, the Australian Government passed emergency law (the Coronavirus Economic Response Package Omnibus Act 2020 (Cth) (Suspension Act)) which came into force on 24 March 2020 and provides temporary (six-month) protection for directors from personal liability for the insolvent trading of a company.

This new law, combined with existing relief under Australian law (refer to the Existing relief under Australian law section below) can provide directors with a pathway to taking more active steps to manage the company, but the steps taken need to fall within the relevant criteria for relief to be given. The criteria are broad and their interpretation is open to differing views. Hence, great care and good advice is needed to ensure each step will attract the relief.

....and some relief for foreign or Australian holding companies

Foreign and Australian holding companies may be similarly at risk of being liable for the debts of their Australian subsidiaries if such subsidiaries trade while insolvent. Such holding companies may also find relief in the Suspension Act provided they take appropriate steps as set out in the Suspension Act (s 588WA(1)).

In both cases – directors and holding companies – the new relief is only temporary in nature and is due to expire on 25 September 2020, unless the government extends this period. An extension cannot yet be assumed at this time.

Directors' new temporary relief under the Suspension Act

The Suspension Act introduces some new relief for directors' personal liability for insolvent trading. There are, however, some hurdles to be passed before enjoying the relief (new s588GAAA of the Corporations Act).

The criteria:

A director will not be liable if the debt is incurred:

1. in the ordinary course of the company's business; and
2. during the six-month period starting on March 25, or any longer period prescribed by the regulations; and
3. before any appointment of an administrator or liquidator of the company during the temporary safe harbour period.

Criteria 1: The "ordinary course of a company's business"

Whether a debt is incurred in the ordinary course of business is a general test and how it applies in any particular circumstance is a question of assessing the facts of that circumstance. There are no comprehensive rules to follow. Therefore, companies are recommended to seek advice for their specific situations.

Some guidance is given in the government's explanatory memorandum: "A director is taken to incur a debt in the ordinary course of business if it is necessary to facilitate the continuation of the business during the six-month period".

Examples include "a director taking out a loan to move some business operations online" and "debts incurred through continuing to pay employees during the coronavirus pandemic".

The breadth of these examples suggests a broad interpretation of the criteria. At common law, events such as recessions can validly explain transactions not normally in the "ordinary course of business".

The provisions and examples are silent on general refinancing using debt or debt instruments. Current sentiment suggests it is not protected under the new Suspension Act provisions, but it may be protected by the existing relief (refer to the Existing relief under Australian law section below).

Criteria 2: Debt incurred during the period

The six-month period began on 25 March 2020 and ends on 25 September (the 'moratorium period'). It does not apply retrospectively to debts incurred prior or after that 6-month period.

Generally, a debt is incurred when, by a company's choice, it does or omits to do something which renders it liable for a debt for which it otherwise would not have been liable. The meaning is flexible and depends on the context.

In ASIC v Edwards (2005) 220 ALR 148, Barrett J said that incurring a debt involves any "act, omission or other circumstance which causes the company to owe the debt".

Key indicators include:

• signing an agreement or otherwise agreeing to an arrangement that will involve, at some point, a financial obligation, even if that obligation does not immediately arise on signing/agreement
• exercising a right that triggers a financial obligation

When does an order for goods or services result in a debt being incurred?

The second criteria may be complicated by orders for goods or services which can be revoked or cancelled at some point prior to delivery. For orders which are not revocable, the court will look to the terms of trade, the nature of the goods, and their marketability as to when a debt is incurred. If goods are readily saleable by the vendor, it is more likely that the debt is incurred at the time of delivery. If the goods are not readily saleable, it is more likely that the debt is incurred upon ordering. Thus, a debt would still be incurred during the moratorium period (and attract the temporary relief) if it was ordered during the six-month period even if delivery is after the six-month period.

For orders which are revocable, the debt is usually incurred when the offer is unable to be revoked; this is often upon delivery or another time as stated under the contract. This will be a question of fact, especially if delivery is after the moratorium period, however a debt may still be incurred even if the contract is contingent on delivery, and directors should seek specific advice.

Ongoing concerns and directors' duties

It is important to note that the Suspension Act does not change or relieve directors from their obligation to comply with their usual duties under the Corporations Act. These continue to apply throughout the moratorium period and any action taken by directors during that period will continue to be judged for compliance with those duties. Those duties are:

• Skill and diligence - exercise powers and discharge duties with the skill and diligence of a reasonable person in that director's shoes in the company's circumstances
• Good faith - exercise powers and discharge duties in good faith in the best interest of the company and for a proper purpose
• Proper use of position - not improperly use their position to gain advantage or cause detriment to the corporation
• Proper use of information - not improperly use information obtained because of a director's position to gain advantage or cause detriment to the corporation
• Conflicts of interest - prevent conflicts of interest and act only in the best interests of the company

Debts still payable

All debts incurred during the moratorium period are still payable. This is critical for directors to contemplate when considering long-term solvency. The interests of creditors must also be considered.

The offence of "dishonest" insolvent trading remains (s588G(3), Corporations Act). Blatant cases of dishonesty and fraud will still be subject to criminal penalties and will not be forgiven by the temporary safe harbour rules.

Directors' duties include a duty to creditors

In continuing to meet their duties to "act in the best interests of the company", directors must consider the interests of creditors. The duty arises when the company is insolvent or where there is a high degree of certainty of insolvency. It is discharged through proper consideration of relevant facts and circumstances. This may include electing to go into administration where future debts will render the company insolvent.

Advice to directors

Critics of the recent amendments say that the Suspension Act may allow otherwise-insolvent businesses to continue to trade, and that it simply "kicks the can" of insolvency and burgeoning debt down the road – whether a company was insolvent prior to the pandemic or as a result of it.

To avoid the risk of personal liability, directors should seek advice regarding their situation and potential relief under the various harbours and defences. After seeking advice, directors may have tough choices to make. Selling vital assets may cripple a business upon return to normal trading. On the other hand, a company's decision to press on and incur more debt to stay afloat may not be viewed kindly by future liquidators.

In this respect, directors should turn their minds to seeking advice, maintaining records and monitoring their company. Directors will need to provide evidence for any future safe harbour proceedings, and these practices will best position directors to reduce their liability.

Existing relief under Australian law

Director liability

It is a defence to insolvent trading liability under this s 588H of the Corporations Act 2001 if:

• the director had reasonable grounds to expect, and did expect, that the company would remain solvent when taking on the debt
• a director obtains advice as to solvency from a competent and reliable person with adequate information
• the director was ill or for some other reason did not take part in management when the debt was incurred (this defence is difficult to establish), or
• the director took all reasonable steps to prevent the company incurring the relevant debt

Safe harbour protection

The Corporations Act also provides specific relief for directors that take appropriate restructuring or recapitalisation steps in attempt to salvage a business nearing insolvency (s 588GA, and s 588WA for holding companies). A director (or holding company) will not be liable if the debt is incurred as a function of the development of a course of action that will likely lead to a better outcome for the company. Such a course should include directors (or holding company):

• properly informing themselves of the company's financial position
• taking appropriate steps to prevent misconduct by employees
• maintaining appropriate financial records, and
• obtaining appropriately qualified advice among others

Our team is actively monitoring and considering the implications of legal and regulatory developments in response to the COVID-19 pandemic. You can find our COVID-19 collection here. You may also be interested in our recent article on the newly determined right of casual employees to have the same leave entitlements as permanent employees and how this may impact directors' duties where insolvency issues may arise.