Insolvency law reform - how the new debt restructuring process will work and its pros and cons

Tom Read, Legal Writer - Practical Guidance, LexisNexis Australia

The most significant reforms to Australia’s insolvency laws in 30 years are due to commence on 1 January 2021 subject to the passing of legislation.

It is important for practitioners to get across key components of the draft legislation released by Treasury to help clients prepare for the changes that are fast approaching, particularly given demand for legal services in insolvency and restructuring is set to rise in 2021.

One feature of the reforms is the new debt restructuring process. We look at how the process will work in practice, based on the exposure draft of the bill, and its pros and cons from the perspective of companies and their directors.

What companies are eligible?

The Treasurer initially announced that companies with liabilities of less than $1 million would be eligible. However, the liability cap and how liabilities are calculated will be set out in regulations, which have not been released at the time of writing.

A company does not qualify if a director has previously used the debt restructuring process or the new simplified liquidation process (another feature of the reforms), although exemptions may apply.

The debt restructuring process is also not available to a company if it is already under restructuring or administration, has executed a deed of company arrangement that has not yet terminated, or where a liquidator or provisional liquidator has been appointed to the company.

How will the debt restructuring process work?

In broad outline, the steps involved in the debt restructure process based on the draft legislation and the earlier Treasury announcement are as follows:

• An eligible company facing financial distress approaches a registered liquidator to discuss the company’s options.
• The board of the company resolves that:
  • the directors have reasonable grounds for suspecting that the company is insolvent, or is likely to become insolvent at some future time; and
  • a small business restructuring practitioner (SBRP) should be appointed.
• The company prepares a plan to restructure the company’s debts (eg unsecured creditors to receive a specified amount in the dollar for their debts). This will take place over a 20 business-day period.
• The SBRP provides advice to the company on matters relating to the restructuring and assists the company to prepare the restructuring plan.
• Company directors must help the SBRP by attending on the SBRP, providing information on the company’s business, property, affairs and financial circumstances and giving the SBRP access to inspect and make copies of company books.
• While a company is under the restructuring process, the company directors retain control of the company. However, the company directors must seek the consent of the SBRP for transactions or dealings outside the ordinary course of business.  The SBRP acts as agent of the company.
• The regulations may require the company to ensure that payments to employees and tax lodgments are up to date before a plan can be put to creditors. The employee entitlement requirement is likely to exclude many companies from the debt restructuring process.
• The restructuring plan and supporting documents are sent to creditors. The SBRP must make a declaration to creditors in relation to the proposed plan in accordance with the regulations. Regulations will prescribe the content of restructuring plans and other matters relating to plans.
• Within 15 business days, creditors vote on the plan, including the proposed remuneration for the practitioner.
• If creditors endorse the plan, it is approved and binds all unsecured creditors. More than 50% of creditors by value will need to vote in favour. Related entities are unable to vote on the plan.
• If the plan is approved, the company continues to operate and the SBRP administers the plan by making distributions to creditors according to the terms of the plan. There will be provision to vary the plan.
• If the plan is voted down, the process ends, and the directors of the company may opt to put the company into voluntary administration or creditors voluntary liquidation (in which case, the new simplified liquidation process is likely to apply as it is intended that the criteria for both processes be consistent).
• The process can also end early, as the SBRP has the power to terminate it if the SBRP forms the view that the company does not meet the eligibility criteria, that entering or continuing a restructuring plan would not be the interests of creditors or that the company should be wound up.

What are the advantages the debt restructuring process?

From the company’s perspective, the main advantages of the debt restructuring process are:

• It offers the opportunity for the company to repay its debts on a compromised basis, continue with a viable business and avoid being wound up.  The company emerges from the approved plan free from the burden of unsustainable debt.
• An eligible company waiting to access the debt restructuring process will be provided with a form of temporary relief from the statutory demand regime.
• The company gets breathing space as court proceedings and enforcement processes are stayed and cannot be begun or proceed during the debt restructuring process, except with SBRP consent or leave of the Court.
• The company gets protections from action by secured creditors, lessors and owners of property used or occupied by the company (consistent with the regime in voluntary administration). For example:
  • as a general rule, while a company is under restructuring, property rights cannot be exercised by third parties in relation to property of the company or property used, occupied by or in the possession of the company, unless the SBRP has consented or leave is granted by the Court;
  • however, a secured party with a security interest over the whole or substantially the whole of the company’s property, either in one or more securities, can enforce their security interest if they act before or during the 13 business-day 'decision period'.
• Winding up applications are adjourned unless the Court is satisfied that it is in the best interests of creditors for the company to be wound up.
• There is protection from third parties relying on ipso facto clauses (clauses which allow parties to terminate contracts because of an insolvency event).
• Directors continue to control the business.  In contrast, under voluntary administration, administrators are in control.
• Only 50% of creditors by value need to endorse the plan.
• The process will be reasonably quick and it is likely to be less costly than the voluntary administration process.
• Ordinarily, restructuring plans will be voted on by creditors through technological means rather than physical meetings.
• Payments made, transactions entered into, or any other acts or things done in good faith by, or with the consent of, the SBRP are valid and effectual and not liable to be set aside if the company is wound up. This is intended to assist in giving confidence to acquirers of company property.
• Company transactions in the ordinary course of business, or by or with the consent of the SBRP during the restructuring process or on behalf of the company by or under the authority of SBRP for the plan cannot be subject to attack as voidable transactions if the company is wound up.

From the perspective of directors personally, the main advantages of the debt restructuring process are:

• Where an eligible company is waiting to access the debt restructuring process, directors are relieved of their duty to prevent insolvent trading.
• Safe harbour protections – a director is exempt from certain insolvent trading rules in relation to transactions within the ordinary course of business, or with consent of the SBRP, while a company is under restructuring.
• Once the process commences, personal guarantees cannot be enforced against a director or one of their relatives without leave of the Court.

What are the disadvantages of the debt restructuring process?

From the company’s perspective, the main disadvantages of the debt restructuring process that apply, or may apply depending on the circumstances are:

• The costs of the debt restructuring process, mainly the costs of SBRP.
• If the debt restructuring fails, for example, if creditors vote down the debt restructuring plan or the SBRP determines that the process should end, many companies will end up going into liquidation, having incurred wasted costs and accumulated further losses.
• Recoveries from business and asset sales are likely to be less in a debt restructuring scenario than if the company is trading normally.
• Suppliers may be discouraged from trading with the company as SBRPs are not personally liable for debts incurred by the company during the restructuring process nor are those debts afforded priority in a winding up.  Directors are not personally liable for such debts either.
• The restructuring plan can only deal with debts incurred by the company prior to entering debt restructuring.  It is less flexible than a deed of company arrangement, which can deal with any aspect of company restructure.
• Only the company directors can propose a debt restructuring plan. In contrast, under voluntary administration, a deed of company arrangement can be proposed by the company, company members, the administrator or creditors.
• As with any form of insolvency process, there may be damage to the company’s reputation. For example, the company may experience unwillingness of suppliers to extend credit and difficulty in securing finance.

From the perspective of directors personally, it should be recognised that if the debt restructuring fails, directors’ personal liabilities may increase due to the company continuing to trade eg personal liabilities under guarantees, ATO director penalty notices and any funding provided to support ongoing trading and the costs of the debt restructuring process.  As with any formal insolvency process, debt restructuring also has potential to negatively affect a directors’ reputation, although such attitudes are less likely where the COVID-19 pandemic has caused a company failure.

It should also be noted that the debt restructuring process contemplates limited investigations by the SBRP of company transactions and director conduct compared to administration and liquidation.

Other options for financial distressed companies

Debt restructuring will be just one of the options directors of companies in financial distress will need to consider.

Directors need to consider what is right for their company, having regard to their various statutory and common law duties, as each company’s circumstances will dictate what is appropriate. The other main options are consensual restructuring, voluntary administration or creditors’ voluntary liquidation (which may incorporate the simplified process to be available for eligible companies under the reforms). For further details about options, see Companies in financial distress – guidance and options for directors.

This article is based on a draft bill and explanatory materials released on 7 October 2020 and the earlier Treasury announcement. Importantly, the draft bill remains subject to change, including as a result of public consultation. In addition, key elements of the reforms will be contained in regulations, a draft of which is has not been released at the time of writing. The functions and duties of the SBRP, in particular, are yet to be clarified.

Contact your Relationship Manager for more in depth information on our Practical Guidance Insolvency module. Alternatively email Sales.Enquiries@lexisnexis.com.au or call us on 1800 772 772