Corporate governance, corporate responsibility

and law
Editor: Jean Jacques du Plessis

GOVERNANCE IN FINANCIALLY TROUBLED COMPANIES:

AUSTRALIAN LAW REFORM PROPOSALS
This note is written by Associate Professor Anil Hargovan, School of Taxation
and Business Law, University of New South Wales

INTRODUCTION
The adverse impact of Australia’s insolvent trading laws1 on attempts at informal corporate rescue,
outside of formal administration,2 continues to attract the attention of the federal government.
Following an aborted attempt by Treasury to address this issue during the global financial crisis in
2010,3 recent initiatives at law reform in 2016 has once again turned the spotlight on the need to do
more to encourage and facilitate the restructure of economically viable companies.4
The impetus for law reform, on this occasion, can be attributed to the overarching goal of the
government to drive efficiency and economic growth in the Australian economy.5
The operation of the current insolvent trading laws, particularly on the timing and effectiveness of
corporate restructuring, was identified as a significant barrier to achieve these economic goals.6 The
current statutory regime encourages companies that are not irretrievably insolvent to be quickly placed
into formal administration and discourages exploration attempts to trade out of difficulty. Risk
aversion, due to potential personal liability of directors for insolvent trading, is also recognised as one
of the key potential causes of arrested economic development.
In paying attention to the impediments of developing a robust entrepreneurial culture in Australia,
the government reflected on the operation of the insolvent trading laws and made the following
pertinent observation:7
Concerns over inadvertent breaches of insolvent trading laws are frequently cited as a reason early stage
(angel) investors are reluctant to get involved in a start-up. Our current insolvency laws put too much focus
on penalising and stigmatising the failures.
Thus, increasing the cultural appetite for risk is seen as an important ingredient to encourage
entrepreneurial support for innovative businesses which may involve higher risks of commercial
failure. To this end, the Productivity Commission, in December 2015, recommended a safe harbour
defence for directors who fail in their restructuring efforts.8
1
See Corporations Act 2001 (Cth) s 588G which prohibits insolvent trading by directors.
2
See Corporations Act 2001 (Cth) Pt 5.3A which provides for voluntary administration.
3
See further Treasury, “Insolvent Trading: A Safe Harbour for Reorganisation Attempts Outside of External Administration”
(Discussion Paper, 2010). For discussion, see A Hargovan, “Director’s Liability for Insolvent Trading, Statutory Forgiveness
and Law Reform” (2010) 18 Insolvency Law Journal 96.
4
Australian Government, “Improving Bankruptcy and Insolvency Laws” (Proposals Paper, 2016) <www.innovation.gov.au>.
5
Productivity Commission, Business Set-Up, Transfer and Closure Final Report 75 (2015). The report was sent to the federal
government on 30 September 2015 but publicly released on 7 December 2015. For discussion, see J Harris and A Hargovan,
“Productivity Commission Safe Harbour Proposal for Insolvent Trading” (2016) 68 Governance Direction 9.
6
Productivity Commission, n 5, 366.
7
National Innovation and Science Agenda, “Improving Insolvency Laws to Encourage Innovation”
<http://www.innovation.gov.au>.
8
See n 5.

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Corporate governance, corporate responsibility and law

Subsequently, the government issued a Proposals Paper, in April 2016, in which it has advanced
two alternate models for law reform to promote a restructuring culture – either a safe harbour defence
(model A) or a carve-out (model B) for directors in respect of the insolvent trading provision in
s 588G of the Corporations Act 2001 (Cth).9
LAW REFORM PROPOSALS
For better or for worse, the Proposals Paper does not contemplate the removal of the insolvent trading
laws from the statute book. The following section offers commentary on the two alternate law reform
proposals.10
Safe harbour defence (Model A)
This new defence will be available if a reasonable director has an expectation based on advice by an
appropriately experienced, qualified and informed restructuring adviser, that the company can be
returned to solvency within a reasonable period of time, and the director is taking reasonable steps to
ensure it does.
Moreover, for this defence to apply, the company must appoint a restructuring adviser who:11
(a) is provided with appropriate books and records within a reasonable period of their appointment to
enable them to form a view as to the viability of the business; and
(b) is and remains of the opinion that the company can avoid liquidation and is likely to be able to be
returned to solvency within a reasonable period of time; and
(c) is required to exercise their powers and discharge their duties in good faith in the best interests of
the company and to inform [the Australian Securities and Investments Commission (ASIC)] of any
misconduct they identify.
It is proposed that the restructuring adviser would be:12
• appointed by the company, not the directors, and thus they owe any duties to the company;
• not be civilly liable to third parties for an erroneous opinion provided that it was honestly and
reasonably held;
• unable to be appointed in any subsequent insolvency without the leave of the Court; and
• specifically carved out of the expanded definition of director (ie would not be a shadow or de
facto director).
It is clear that the proposal under Model A intends the restructuring adviser to play a crucial
gatekeeping role in a safe harbour. Gatekeepers have a key role to play in promoting corporate
responsibility, to detect and report corporate misconduct and are heavily relied upon by stakeholders
for effective corporate governance. Gatekeepers, naturally, are expected to act with honesty, integrity,
ethically and to provide assurance that they are discharging their duties diligently.
In the wake of a series of corporate governance disasters in the United States (Enron, WorldCom)
and in Australia (HIH), members of the “gatekeeping” professions playing a watchdog role did not
bark on their watch – an epic demonstration of gatekeeping failure by auditors due to the compromise
in the values and standards of those professional members who failed to spot and prevent corporate
misconduct.
To prevent, or minimise, such history repeating, it is indeed appropriate for the restructuring
adviser to be appropriately experienced, qualified and informed – as envisaged under Model A.
Although not explicitly spelt out under the proposal, it is also essential to ensure that the restructuring
advisor also fits the character test and is a “fit and proper” person to perform the task. To underscore
the importance of these criteria, the proposals should also go a step further and include it in the
regulations, analogous to the way in which the professional requirements to be a registered liquidator
are referenced in s 1282 of the Corporations Act.
9
Other law reform proposals, dealing with reducing the period of personal bankruptcy and with making ipso facto clauses void
in an insolvency event, falls outside the scope of this article.
10
Public submissions for these proposals closed on 27 May 2016.
11
Australian Government, n 4, 11
12
Australian Government, n 4, 13.

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The details of the experience and qualifications are not spelt out in the Proposals Paper. It would
be desirable, at minimum, for the restructuring adviser to have at least three years of relevant
experience, similar to the threshold requirement to becoming a member of the Australian
Restructuring, Insolvency and Turnaround Association (ARITA), and should have academic
qualifications similar to those of a professionally qualified accountant or lawyer. It is therefore
imperative, in order to minimise the scope for sham or phoenix activities, for the restructuring adviser
to be an accredited member of an organisation with its own disciplinary framework, education
framework and ethical standards.
ARITA meets all of the essential criteria (disciplinary framework, educational framework and
ethical standards set out in its Code of Professional Practice) and appears to be well positioned to
discharge the responsibilities expected from an accredited organisation from which restructuring
advisers are to be appointed. Should the government accredit ARITA for such purposes, it will provide
stakeholders with a great deal of assurance that the risk, if any, of gatekeeper failure will be low.
A potential disadvantage of this option is that it may narrow the pool of restructuring advisors and
drive up costs. This, however, may be satisfactorily addressed by increasing the number of accredited
organisations to include members of the Law Society, Turnaround Management Association or
accountancy bodies, such as CPA Australia and Chartered Accountants Australia and New Zealand.
Competitive pressure may assist to overcome the cost barrier, particularly for smaller businesses in a
precarious financial position.
The proposed exclusion of the restructuring adviser from the expanded statutory definition of
director (de factor or shadow) under Model A is a positive step and worthy of reinforcement for
reasons below.
The current statutory definition of director in s 9 of the Corporations Act provides a carve out for
situations where a director acts on advice given by a person in the proper performance of functions
attaching to the person’s professional capacity, or the person’s business relationship with the company.
Arguably, restructuring advisers acting in a professional capacity are currently excluded from the
current statutory definition of director.
That said, it is important to remember judicial warnings that labels or descriptions given to
persons instructing the company to act according to their wishes are not intended to be prescriptive.13
In such circumstances, courts have repeatedly expressed caution on becoming fixated with, and
blinded by, labels given to persons.14 It is also significant to note that courts are free to come to their
own conclusion on the status of a person involved in management after a critical assessment of the
way in which the company is managed.15
In light of the approach advocated by judicial authorities, the proposed carve out should not be
viewed as superfluous – it has real work to do to ensure that restructuring advisers are not treated as
directors, owing the full range of directors’ duties – both fiduciary and statutory under the
Corporations Act.
Without such an express carve out for restructuring advisers, potential exists for the goals of the
safe harbour defence to be impeded due to lingering concerns over the adviser’s potential liability for
insolvent trading. It is relevant to note, albeit in a different context, that the expanded definition of

13
See Australian Securities and Investments Commission v Murdaca (2008) 68 ACSR 66; [2008] FCA 1399, [11]; Grimaldi v
Chameleon Mining NL (No 2) (2012) 200 FCR 296; [2012] FCAFC 6.
14
See Australian Securities and Investments Commission v Murdaca (2008) 68 ACSR 66; [2008] FCA 1399, [11]; Grimaldi v
Chameleon Mining NL (No 2) (2012) 200 FCR 296; [2012] FCAFC 6.
15
See Australian Securities and Investments Commission v Murdaca (2008) 68 ACSR 66; [2008] FCA 1399, [11]; Grimaldi v
Chameleon Mining NL (No 2) (2012) 200 FCR 296; [2012] FCAFC 6.

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director has caused concern among creditor financial institutions and professional advisers during
corporate insolvency – as illustrated in several litigated cases.16
An express carve out, such as the version contained in Model A, squarely addresses potential
obstacles to securing appointments and is likely to add to the efficacy of the safe harbour defence.
The requirement for the restructuring adviser to be provided with appropriate book and records is,
with good reason, an essential criteria for the operation of the safe harbour defence in Model A. This
requirement should help ensure that the defence is used by those with “clean hands” with
demonstrated good governance.17 Although the possibility exists for under-utilisation of this defence
due to director failure to comply with the need to keep proper books and records, this requirement will
hopefully incentivise compliance with the Corporations Act in this respect.
Statutory carve out (Model B)
This model seeks to provide directors who are acting in the best interests of the company and its
creditors as a whole with a safe harbour within which they may attempt to return the company to
profitability. It does so by modifying the current operation of s 588G of the Corporation Act in the
following way. Section 588G will no longer be applicable if:18
(a) the debt was incurred as part of reasonable steps to maintain or return the company to solvency
within a reasonable period of time; and
(b) the person held an honest and reasonable belief that incurring the debt was in the best interests of
the company and its creditors as a whole; and
(c) incurring the debt does not materially increase the risk of serious loss to creditors.
Model B appears to be a more flexible and attractive proposal than Model A. In contrast to Model
A, it seeks to encourage greater creditor engagement with the insolvent company to work out a
recovery solution. It also appears to offer the benefits of simplicity. This, however, may not necessarily
be the case as the carve out is predicated on the director taking “reasonable steps” and returning the
company to solvency within a “reasonable time”. These key threshold requirements are not defined
and this flexibility may be a double-edged sword – it may also represent its weakness through lack of
guidance. However, it is encouraging to note that indicia of both “reasonable steps” and “reasonable
time” are intended to be included in the Explanatory Memorandum accompanying the legislation.19
Model B also appears to be a deceptively simpler and cheaper process due to the absence of any
express reference for the director to appoint a restructuring adviser. Such an appointment, which is
bound to be costly, however, is nonetheless contemplated by the government.20 Consequently, if this is
to materialise, it may also engender a reasonable expectation by the court for a restructuring adviser to
be appointed. The Proposals Paper flags that the appointment of an appropriately qualified and
experienced restructuring adviser will help inform whether the director has satisfied the first limb of
the carve out, set out above.21 Should this become a regular expectation in practice, Model B has great
potential to present false economy and flexibility.
The second limb of the carve out in Model B, requiring a director to have a “honest and
reasonable belief”, uses language that is appropriate and familiar in corporations law. The term

16
Emanuel Management Pty Ltd (in liq) v Foster’s Brewing Group Ltd (2003) 178 FLR 1; [2003] QSC 205; Buzzle Operations
Pty Ltd (in liq) v Apple Computer Australia Pty Ltd (2011) 81 NSWLR 47; [2011] NSWCA 109. See further A Hargovan,
“Throwing Light on Shadow Directors – Court of Appeal in Buzzle v Apple Computer” (2011) 10 Insolvency Law Bulletin 173.
17
Productivity Commission, n 5, 382.
18
Australian Government, n 4, 15.
19
Australian Government, n 4, 16.
20
Australian Government, n 4, 16.
21
Australian Government, n 4, 16.

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“honestly” is used in many sections of the Corporations Act (such as ss 1317S and 1318) and has been
subject to judicial interpretation on many occasions, with its commonly held meaning ascribed to as
conduct that is:22
without moral turpitude in the sense that it is without deceit or conscious impropriety, without intent to gain
improper benefit or advantage and without carelessness or imprudence at a level that negates the
performance of the duty in question.
Model B contemplates the safe harbour as a carve out, rather than a defence. Thus, the Proposal Paper
suggests that the burden of proof would lie on the liquidator to establish the director had breached any
one of the three limbs of this proposal.23 Presumably, the burden of proof would also lie on ASIC as
the corporate regulator – the Proposals Paper is silent on this key issue.
From a law enforcement and deterrence perspective, the proposal to place the burden of proof on
the liquidator (and ASIC) is questionable. Arguably, it would be more effective for such purposes to
get the director to bear the burden of proof and show that they have complied with all three limbs of
the carve out under Model B. This more stringent approach could conceivably be supported as a
necessary consequence of the more lenient approach Model B adopts to the insolvent trading law.
THE WAY FORWARD
The reform options for insolvent trading law advanced in the Proposals Paper are a long overdue but
positive development – it signals that the law is seeking to temper its own severity.
The operation of the current statutory defences under s 588H adds little comfort to director
concerns over risk of personal liability for insolvent trading.24 Robust judicial interpretation of the
defences adds credence to the claim that the law of insolvent trading is under a great deal of pressure
from directors who believe the present defences are too hard to satisfy.25 Moreover, relief from
personal liability based on judicial discretion under s 1317S has been the exception rather than the
norm.
Notwithstanding the rare results in McLellan v Carroll26 and Hall v Poolman27 where the director
was fully and partially relieved from liability respectively, significantly, in both cases the director
failed to satisfy their statutory defences under s 588H.
Ominously, despite the director’s success in McLellan v Carroll under s 1317S, the court departed
from the usual rule as to costs and ordered the director liable for the liquidator’s costs. The court was
heavily influenced by the fact that the liquidator succeeded in establishing all the integers of the claim
under s 588G but was defeated by s 1317S of the Act. Such results further underscore the practical,
and costly, difficulties faced by honest directors who make genuine attempts to salvage the company
outside of formal administration.
Another positive feature of the law reform proposals is that it genuinely seeks to encourage
directors to act on insolvency concerns early and to attempt informal workouts with creditors when
appropriate.
Early and genuine engagement with creditors to explore agreements that renegotiate, reduce,
delay or waive pre-existing debts or terms of trade is desirable for companies in financial difficulties
and has potential benefits. The goals of such informal workouts are for the company to turnaround and
continue trading, with creditors benefiting from payment and other stakeholders benefitting from
corporate survival.
22
Australian Securities and Investments Commission v MacDonald (No 12) (2009) 4 BFRA 1; [2009] NSWSC 714.
23
Australian Government, n 4, 15.
24
For analysis on the operation of each defence under Corporations Act 2001 (Cth) s 588H, see J Harris, A Hargovan and
M Adams, Australian Corporate Law (5th ed, LexisNexis, 2015) Ch 18.
25
R Austin and A Rathmell, “An Introduction to the Conference Theme” in RP Austin and AY Bilski (eds), Directors in
Troubled Times (Ross Parsons Centre of Commercial, Corporate and Taxation Law, 2009) 10, 14. See further A Hargovan, n 3.
26
McLellan v Carroll (2009) 76 ACSR 67; [2009] FCA 1415.
27
Hall v Poolman (2007) 215 FLR 243; [2007] NSWSC 1330.

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The reform proposals addresses the current imbalance in the operation of the insolvent trading
laws which is skewed towards putting the company into voluntary administration too readily for
director fear of the threat of personal liability.28 It tackles legitimate concerns that current director
behaviour is likely to continue to be overly risk-averse, shunning opportunities at company
reorganisation outside of formal administration.
It is important, however, for any new law to strike an appropriate balance between protecting
creditor interests and facilitating sensible commercial risk taking to return the company to long term
viability, even if there is some risk of loss in the short term.
The promotion of a greater cultural appetite for business risk, desirable as it is, however should
not come at the deliberate expense of employees and the wider community. Whichever proposal the
government decides upon, it is essential to ensure that the new measures are designed to maintain
good governance and to eliminate the prospect of the law becoming a rogue’s charter for reckless
trading or phoenix activities.

28
Productivity Commission, n 5, 366.

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