Insolvency laws in Australia

Dr Nitin Gupta, Economics

Key Issue
Creating a culture of innovation means striking a balance between promoting productive and discouraging reckless risk-taking. Insolvency laws help to strike this balance.
Australia’s insolvency laws are increasingly out of sync with trends across much of the OECD, and risk undermining the innovation outcomes of the Australian economy.

A broad context

The importance of innovation as a means to promote growth has been an important part of the Government’s policy agenda. This is because the mining boom—the mainstay of the economy for the last two decades—is coming to an end, and there is a broad consensus that the boom has obscured a general decline in national productivity.

The ways in which an economy encourages and regulates risk are critical to its innovation outcomes. The rules have to strike a balance between promoting risk-taking on one hand, and minimising the possibility that risk protections lead to abuse and reckless behaviour by companies (the moral hazard problem) on the other. Insolvency laws are an important marketplace mechanism by which countries try to strike this balance.

Insolvency laws fall broadly into two groups. In the first are those that prioritise liquidation of a company over its restructuring. These assume that insolvency is the result of deliberate malpractice by companies, and accordingly, place greater emphasis on the protection of creditors. In the second are laws that reflect a ‘rescue culture’ that allows for financially constrained companies to reorganise themselves rather than be forced into liquidation. These assume that insolvency may not reflect deliberate malpractice and that a second chance for the company will be in the longer-term interest of creditors.

Insolvency in Australia—the key issues

Under the Corporations Act 2001, a person is solvent if, and only if, the person is able to pay all the person’s debts, as and when they become due and payable’. Thus ‘a person who is not solvent is insolvent.’

Australian insolvency law does not take account of an insolvent company’s longer-term prospects, its competitiveness, assets, or brand value, and is geared towards its premature closure and liquidation. It does not allow for the possibility that, through some restructuring or assistance, the company could return to profitability and preserve the interests of creditors.

Bankruptcy laws in other advanced countries

Globally, insolvency laws have tended towards restructuring rather than liquidation. The ‘Chapter 11’ (Ch. 11) provisions of the US Bankruptcy Code are considered the most liberal, and place great emphasis on corporate rescuing. These provisions have been used as a model for insolvency law reforms in several other countries.

Some of the key advantages of the Ch. 11 approach are that they provide:

  • higher planning reliability, avoiding short-term thinking in decision making
  • continued employment and wages for workers and
  • preservation of skills and experience, brand name and relationships. These intangible assets are highly valued and can take years to build.

In the last few decades the UK, Germany and Canada have all recognised the value of an effective insolvency regime for driving innovation, and have implemented reforms—based on Ch. 11—with the explicit aim of creating a ‘rescue culture’ rather than one based on liquidating an insolvent company.

In the UK, insolvency laws are based on the recommendations of the 1982 Cork Report which reasoned that restoring the profitability of companies would be in the longer-term interests of creditors. Until about 2008, German law was geared towards liquidation of a debtor’s assets. Since then, laws have been progressively reformed to improve the possibility of corporate restructuring, and also to raise the profile of German insolvency law versus foreign jurisdictions. Canada has implemented several reforms since 1992, and also has special provisions for large companies owing more than $5 million.

Laws in these countries broadly follow Ch. 11 by preventing creditors from liquidating a company’s assets while the latter is underdoing restructuring. However, unlike Ch.11 which allows an insolvent company’s directors to retain control over its operations, these countries typically have greater scrutiny and involvement by the courts, including passing of operational control to a court-appointed monitor.

Proposed reforms in Australia

Both Labor and Coalition Governments have proposed changes to the Australian insolvency laws in order to modernise them.

The Ch. 11 provisions have provided a useful reference point for Australia’s thinking on insolvency law reforms. Over several years, multiple reviews have yielded a general view—illustrated by the 2004 Joint Committee inquiry into insolvency, and the 2015 Productivity Commission inquiry into Business Set-up, Transfer and Closurethat a Ch. 11-style framework would be inappropriate for Australia. The specific objection was that an insolvent company’s directors should not be in control of operations once insolvency is declared.

In this vein the National Innovation and Science Agenda (NISA), announced by the Government in December 2015, proposed several changes to the insolvency laws, including:

  • reducing the current default bankruptcy period from three years to one year
  • introducing a ‘safe harbour’ provision to protect directors from personal liability for insolvent trading if the company is undertaking a restructure and
  • making the ‘Ipso Facto’ clause, which allow contracts to be terminated solely due to an insolvency event, unenforceable if the company is undertaking a restructure.

No legislation to give effect to these changes had been introduced prior to the prorogation of the 44th Parliament. However, the Government demonstrated its interest in insolvency reform with the passage of the Insolvency Law Reform Act 2016, which aligned standards for corporate insolvency practitioners with those of personal bankruptcy practitioners.

 

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