Directors’ duties during COVID-19

Authors: Sean Gollin Partner Dispute Resolution and Litigation, MinterEllisonRuddWatts and Leon Bowker. Director, Deal Advisory, KPMG

COVID-19 has had a profound adverse impact on businesses and those governing them. It’s left businesses struggling with liquidity and creditor pressures. Many businesses may be unable to pay debts as and when they fall due and may be technically insolvent.

Directors have a range of duties, some of which are specifically engaged in the event of insolvency:

Companies Act Section 135: not to carry on business in a manner likely to create a substantial risk of serious loss to creditors; and

Companies Act Section 136: not to incur an obligation unless the director believes on reasonable grounds that the company will be able to perform the obligation when required.

When facing the prospect of insolvency, directors are expected to undertake a “sober assessment” of the company’s actual and prospective financial position and performance and the potential for remedying the company’s insolvency.

A “sober assessment” is difficult when the events are unprecedented and there’s no clarity around the recovery period.

Temporary relief

This uncertainty risks otherwise viable businesses being unnecessarily shut down to mitigate the exposure to personal liability. It’s against this background that the government announced proposed temporary changes to our insolvency law regime. It’s worth noting the following:

They are intended to be temporary as a specific response to the COVID-19 crisis;
The detail of how they will operate remains subject to drafting of the legislation;
Safe harbour is intended to apply from 3 April, but Business Debt Hibernation will only be available once the legislation is passed; and
The reforms are to assist businesses which were healthy prior to COVID-19, not those already in trouble.

Safe Harbour provisions

They are to operate to temporarily relieve directors from liability for breach of sections 135 and 136 of the Companies Act only, provided three criteria are satisfied:

in the good faith opinion of the directors the company is facing or is likely to face significant liquidity problems in the next 6 months as a result of the impact of the COVID-19 pandemic on them or their creditors;
the company was able to pay its debts as they fell due on 31 December 2019; and
the directors consider in good faith that it is more likely than not that the company will be able to pay its debts as they fall due within 18 months (for example, because trading conditions are likely to improve or they are likely to be able to reach an accommodation with their creditors).

The time period of 18 months should allow a reasonable runway within which to return to a position of cashflow solvency. That need not be entirely due to improved trading conditions. It might be achieved through raising debt or equity, or reaching an accommodation with creditors potentially through the Business Debt Hibernation (“BDH”) scheme or a Creditors’ Compromise.

A good faith opinion means an honest belief, which is a relatively low threshold and allows some scope for getting things wrong. Meeting the criteria is not a “set and forget” function. Directors need to constantly review whether the criteria continue to be satisfied, particularly before incurring new obligations.

To be a good faith opinion, you will need to demonstrate a basis for the view formed and you should consider preparing:

Detailed weekly or daily cashflow forecasts (over a 13 – 17 week period) to form a robust view of cash availability, liquidity constraints and ability to manage solvency;
Robust 12 – 18 month projections which should consider a range of scenarios with some support for the key assumptions;
The assumptions and forecasts will need to re-evaluated regularly as a clearer picture of the economic impact emerges.
Boards will need to challenge the forecasts and assumptions to understand the level of rigour in their preparation; and
The forecasts will need to factor in the prospect of meeting new commitments in addition to existing commitments in a constrained economic environment.

While many businesses might already have existing treasury policies regarding cashflow management, these should be reviewed as part of your COVID-19 response to ensure they remain fit for purpose. We consider that as part of your overall governance and risk management framework you should also:

Prepare a communication plan to actively manage stakeholders to ensure they continue to support you through this process;
Document the reasons for the views formed and the information relied on as part of that process;
Proactively formulate a plan for moving forward and continually reassess it, particularly as and when circumstances change; and
Seek the assistance of advisors, particularly financial advisors when financial assessments and modelling need to be undertaken.

Business Debt Hibernation

BDH is intended to provide a breathing space through a moratorium on enforcement of debts by creditors, to enable an affected business time to either successfully trade out of the crisis if possible or formulate a plan to put to creditors for more substantively restructuring its debts if that’s feasible.

A business that meets a yet to be specified threshold will invoke the scheme by putting a proposal to its creditors. On doing so, there is an automatic moratorium against enforcement of existing debts for one month;
Within that month, creditors are to vote on whether to approve the proposal. If so, the moratorium is extended for a further 6 months;
The moratorium affects all creditors, other than employees;
If creditors do not approve the proposal, the moratorium ends and creditors can enforce their debts in the usual way;
If the proposal is approved, existing debt is effectively frozen and the business trades on subject to any conditions imposed by creditors; and
Voting is likely to be done electronically and requires a majority in number representing 50% in value of creditors who participate.

The scheme should be used as a last resort for a liquidity constrained business that has good prospects and requires breathing space to develop a restructuring plan.

Before preparing a proposal, proponents should have a clear picture on cashflow requirements, and what timeframe and additional restructuring is required to manage the liquidity issues.

Prior to presenting any proposals to creditors, businesses should seek views of key stakeholders, particularly their banks, to discuss options and views on the proposal and whether any conditions might be required to get their support.

Businesses will also need to carefully consider their ability to meet deferred debt obligations post the hibernation period on top of normal trading obligations incurred. This may require some staggering of commitments.

Some businesses might consider using this in conjunction with a Creditors’ compromise proposal to restructure the balance sheet and provide a stable base to continue trading.

In the event there is no realistic path forward, other insolvency options may need to be considered.

Managing customer risk

BDH may have significant implications for suppliers with multiple customers qualifying for the scheme and likely invoking it at the same time. Hibernating existing debt across numerous customers may create liquidity issues for suppliers as well.

How you respond to a BDH proposal depends on how you view the outcome under BDH compared with the likely alternative of liquidation. If you see benefit in an ongoing supply arrangement:

stipulate payment and other terms for doing so, including tightening credit terms or even requiring cash up front;
payments received while trading under BDH are free from claw back. So if you are concerned about a customer’s solvency, it may actually be in your interest to encourage that customer to invoke BDH;
there may be scope for approval of a proposal to be conditional on part payments being made if the business’ financials indicate there is room for this.
other conditions might also be imposed, such as that the debtor regularly report to its creditors while operating under BDH.

In the end, a decision whether to support a BDH proposal needs to be on an informed basis. The debtor should be required to disclose to creditors its actual and projected financial position and to explain why allowing more time would improve the prospects for a better outcome for them.

See recorded IoD webcast with Sean and Leon for further information (member-only access).