Okay. I’m a small business. I’m not trading because of COVID-19. Does this mean I’m insolvent?
OKAY. I’M A SMALL BUSINESS. I’M NOT TRADING BECAUSE OF COVID-19.
DOES THIS MEAN I’M INSOLVENT?
The short answer to his question is: probably yes!
The legal definition of insolvency is the inability to pay debts as and when they fall due. If a small business cannot pay its employees or contractors, or its landlord, or its suppliers, because it is not trading due to COVID-19 and probably will not be able to trade until 1st September, 2020, then that small business is insolvent.
What is the consequence of a small business being insolvent?
Well, first and foremost, a director of a company has a positive duty to prevent any company incurring a debt at a time it is insolvent or by virtue of which it would become insolvent. That is probably why you are not trading at present. If you were to continue to trade whilst insolvent, and the company conducting the business was liquidated, you as director could be made personally liable for all debts incurred in breach of that duty.
Because of the COVD-19 emergency, the Commonwealth Government has relaxed some of the insolvency rules. For instance, the threshold debt level for personal bankruptcy or corporate liquidation has been raised to $20,000.00. More importantly, the time to respond to a bankruptcy or liquidation demand has been extended to six months. This extension applies to demands served on or after 25th March, 2020. Effectively, small businesses have a breathing space until September, 2020.
Does that mean that small business owners can sit back at home and simply watch Netflix until September? Obviously, no it does not. Come September, 2020, if nothing has been done, the business will still be insolvent. If you have not traded for six months, you will have no assets, no profit and no liquidity. As soon as you open the doors, your re-employed staff, landlord and suppliers will all start demanding payments which you will not have. Bankruptcy or liquidation will shortly follow particularly as the Government’s emergency measures might not have been continued after September, 2020.
What, then, should small business owners be doing now? The simple answer is that small business owners should be taking advantage of the Safe Harbour Defence to insolvent trading. What is the Safe Harbour Defence?
In 2017, Section 588GA was introduced into the Corporations Act to create a specific defence to a claim for breach of statutory duty where a director develops a plan that is reasonably likely to lead to a better outcome for creditors when insolvency is suspected. Armed with that plan, the business can then incur debts. However, for the director to take advantage of the Safe Harbour Defence, he or she must identify a course of action reasonably likely to lead to a better outcome which is better than administration or liquidation, must meet all employee entitlements as they fall due and must ensure that all ATO and ASIC lodgments are up to date. The latter requirement can be a real problem.
Essentially, our advice is for small business owners to contact a Safe Harbour Advisor now and start preparing the plan required by Section 588GA. This means that when the economy returns to “normal” (whatever that means!), the business will be able to incur debts provided the Safe Harbour plan has been formulated in accordance with the above rules. Ultimately, if your business still then fails and does ultimately go into administration or liquidation, whilst this would be a personal disaster, it would at least avoid personal liability for the director of an insolvent company which continued to incur debt.
The current period of time should be seen as a hibernation. Whilst hibernating, wise businesses need to plan for the future. Directors need to remember that, sooner or later, things will get back to normal as will ordinary legal processes and creditors will start enforcing debts.
So, how safe is “Safe Harbour”?
Directors who are owners of small businesses need to remember two warnings. First, Safe Harbour will not protect a director from breaches of any other duties such as the duty to act in the best interests of the company and its shareholders, to avoid conflicts of interest, and to act honestly. Any of these breaches can still be the subject of prosecutions by ASIC for civil penalties and, if dishonesty is involved, for criminal prosecution and by shareholders for oppression. Secondly, smart creditors (or dumb creditors being advised by smart lawyers!) will understand that there is a way around the emergency relaxations of the insolvent trading rules regarding debt levels and times to respond to statutory demands. Those creditors will make application by originating motion to either the Federal Court or Supreme Court of Victoria pursuant to Section 459P. That section simply allows a creditor to wind up a company if it is insolvent. Insolvency may be proved by admissions to the effect that the small business has stated in writing that it is not going to pay its debts during the current emergency period. If the small business debtor cannot pay, the business is insolvent. The creditor applicant can make court application, then issue a notice to produce to review bank records and management accounts which will probably show that the business is insolvent. That creditor can then file a summary judgment application if the review of the evidence shows that the debtor is insolvent. Whilst the courts will not like this approach, it is still the law. The creditor will need to be able to comply with the Civil Procedure Act and must be able to certify that there is a proper basis for the proceedings. It can do this if the unwise debtor has written to creditors saying that it has ceased trading from March, 2020 because of COVID-19. In these circumstances could a debtor tenant try and make use of the Victorian Government moratorium for retail and commercial leases to not pay rent? This moratorium became law on 23rd April, 2020 in the COVID-19 Omnibus (Emergency Measures) Act 2020. Applying for that rent moratorium could be construed as an admission of insolvency. Could the small business tenant then use the new legislation as a shield against a winding up application by a creditor under Section 459P? In our view, that defence by the tenant would be unsuccessful. Generally, Commonwealth law overrides inconsistent State law. Alternatively, what happens if the small business is the insolvent landlord of a commercial tenancy faced with a tenant adopting the rent moratorium as part of a Safe Harbour strategy. Is the liquidator of the landlord prevented from evicting the tenant by the COVID-19 Omnibus (Emergency Measures) Act 2020? No. The liquidator will disclaim the lease under the Corporations Act, thereby ending the lease and forcing the tenant to leave.
In summary, small businesses have a breathing space within which to hibernate. Wise wombats seldom sleep throughout the entirety of hibernation. They are aware of potential predators and lay plans as to what to eat when spring comes. Take a leaf from nature’s book. Do not assume that the current moratorium to September, 2020 means that your small business is immune from any insolvency threat. Furthermore, start planning for a Safe Harbour resurrection. Don’t know who a Safe Harbour advisor is? Simple. Ask us. Alternatively, look for the people with bags under their eyes or haggard looks.
This article is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render legal advice. No reader should act on the basis of any matter contained in this article without first obtaining specific professional advice.
DISCLAIMER: We accept no responsibility for any action taken after reading this article. It is intended as a guide only and is not a substitute for the expert legal advice you can get from De Marco Lawyers and other relevant experts.