Struggling business? Why you might need to use the new ‘Safe Harbour’ provisions.

Inside Franchise Business: The 'Safe Harbour' provision can help financially troubled franchisesThanks to new Commonwealth legislation directors of struggling franchised businesses now can be more comfortable when trying to get a business back on its feet financially. Here’s how it works…

What is ‘safe harbour’

Prior to 19 September 2017, the Corporations Act provided that a director who traded a company that was insolvent was personally liable for the debts of the company from the date the company started trading whilst insolvent.

That often meant that out of fear of incurring personal liability directors would err on the side of caution and place the company into a formal insolvency process (i.e appoint an administrator or attempt a scheme of arrangement) to seek to restructure a company’s affairs rather than attempt to trade the company through to a better financial position.

The Commonwealth government however amended the Corporations Act to introduce a new section, 588GA, which provides a carve out or ‘safe harbour’ for directors from personal liability for insolvent trading where certain conditions are met.

When it can be used….. and when it cannot

The elements that must be satisfied to create to argue that a company is in safe harbour are:

(a) the director ‘starts to suspect’ that the company is or may become insolvent; and

(b) the director begins to take steps to develop courses of action that are ‘reasonably likely to lead to a better outcome for the company’; and

(c) covers a debt that was incurred directly or indirectly as a result of the course of action developed

It is up to a director to demonstrate that each of the elements are met. If the elements are found to be satisfied, the director will not incur personal liability for insolvent trading.

Safe harbour will not be available to directors:

(a) where a debt was incurred and the company was failing to pay entitlements to its employees or give tax returns or other taxation documents by the due date. This failure must be ‘less than substantial compliance’ or must be one of at least two failures during the previous 12 months.

(b) where after the debt was incurred there is a failure to provide information and books of the company to controllers of company property or liquidators.

When it will stop applying

The ‘safe harbour’ ends at the earliest of:

(a) the end of a reasonable period after the director fails to take the cause of action within a reasonable period after that time;

(b) when the person ceases to take the course of action;

(c) when the cause of action ceases to be reasonably likely to lead to a better outcome for the company; or

(d) when there is an appointment of an administrator, or liquidator, of the company.

How to prove its use

For a director to be able to effectively demonstrate the point in time that a company has entered safe harbour it would be prudent to ensure that there is documentary proof of the date the director starts to suspect that the company may become insolvent and the course of action proposed to be adopted to achieve a better outcome than a formal insolvency appointment.

This may include:

(a) minutes of directors meetings;

(b) emails exchanged between directors of the company or between the directors and their advisers;

(c) formal advices received from reasonably qualified advisers (such as lawyers, accountants, turnaround management professionals or other advisers) about a course of action proposed to result in a better course of action for the company.

Considerations for franchise systems

A company operating under a formal insolvency appointment is required by law to place after the company name the words (Administrators appointed) (in liquidation) or (subject to Deed of Company Arrangement).

No such requirement exists for a company operating under ‘safe harbour’. Therefore it will be impossible to tell if you are dealing with a company operating in safe harbour unless this information becomes public.

However, if the directors of a franchisor entity are seeking to utilise this ‘safe harbour’ then they have formed the view that the company is insolvent or may become insolvent.

This will result in a need to provide an update to their disclosure document within 14 days of the view being formed, according to the operation of clause 17 and Annexure 1 clause 22 of the Franchising Code of Conduct, as the director’s view will constitute a material change in the franchisor position from the date of the disclosure document and the date it is provided.

The danger, if an update is not provided, will be a court may find that no current disclosure has been undertaken in compliance with the Code and that this will constitute a breach of the Competition and Consumer Act which may lead to rescission of any franchise agreements entered into without that disclosure being provided as occurred in Spar Licensing Pty Ltd v MIS Qld Pty Ltd (No.2).

The downside will be that a potential franchisee may not wish to purchase a franchise unless it is satisfied that the course of action proposed will ensure the survival of the franchise and enable the franchisor to perform its obligations under the franchise agreement.

Where the company operating under safe harbour is a franchisee, franchisor’s may wish to think about including in their franchise agreements a requirement for franchisees to notify the franchisor if they intend to utilise the safe harbour provisions.