Last month, we predicted that the government would relax reckless trading rules and introduce a safe harbour for directors. The government’s recent announcement of a temporary safe harbour for directors and the business debt hibernation scheme is a positive step to help struggling businesses and company directors under pressure. Further to our article published last week, we examine these changes in more detail.

Safe Harbour

Under s135 of the Companies Act 1993 (CA), directors must not trade a company’s business recklessly. Reckless trading is where directors allow a company’s business to be carried on in a matter likely to create a substantial risk of serious loss to the company’s creditors. Directors are also prohibited from agreeing to an obligation (e.g. a debt) unless the directors reasonably believe that the company will be able to perform the obligation (s136 of the CA). Directors who breach these duties can be required to compensate the company for an amount that is just. Since the Mainzeal decision last year, where the court ordered that the directors compensate the company for a total of NZ$36 million, many directors have been paying closer attention to their reckless trading duties.

The new ‘safe harbour’ provisions will provide directors with shelter from these duties for the next six months. Directors will be able to continue to trade a company and incur fresh obligations where:

• In the directors’ opinion (which must be held in good faith), the company is facing or is likely to face significant liquidity problems in the next six months due to the COVID-19 pandemic;
• The company could 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 the next 18 months (for example, utilising the business debt hibernation scheme to get the business back on track).

The safe harbour provisions do not provide directors with a free pass. Directors of a distressed company will need to carefully plot and chart a business recovery plan to navigate the company out of troubled waters and will always need to act in good faith. If a company was insolvent as at 31 December 2019 or there is no reasonable prospect of a rescue plan to return the company to an ‘even keel’, a director will need to cease trading or risk personal liability for breach of duties.

Business debt hibernation

The government will implement a new business debt hibernation scheme to give businesses short term relief from their debts. The main components of the scheme are:

• A business can propose entry into the scheme and its creditors will have one month from when the proposal is notified to vote on the proposal. During this month, there will be a moratorium on the enforcement of debts;
• A majority of creditors (50% in number and in value) must support an applicant’s entry into the scheme;
• If creditors approve the applicant’s entry into the scheme, there will be a moratorium on the enforcement of debts for six months once the proposal is passed. The scheme will be binding on all creditors except employees; and
• While a business is operating in the scheme, further payments or dispositions made by the company to third party creditors (other than related parties) will be exempt from the voidable transactions regime. This exemption will incentivise creditors to continue supplying goods on credit to a company subject to the scheme. 

Most legal entities will be eligible for the scheme, including companies, partnerships, incorporated societies and trusts. The scheme will not, however, extend to registered banks, non-bank deposit takers, licensed insurers, or sole traders. Sole traders are excluded from the scheme because there is no legal separation between their business debts and personal debts. A sole trader seeking relief from their debts must either reach an informal arrangement with their creditors or utilise the formal procedures in the Insolvency Act 2006, such as a creditors’ proposal.

The government will need to carefully consider some important matters when enacting the scheme, including:

• The rights of secured creditors. Will secured creditor debt be subject to the scheme? Will a business need to achieve a majority in number and in value of creditors by class (i.e. a majority of both secured creditors and unsecured creditors for entry into the scheme)? Will secured creditors still be able to appoint receivers or repossess property? Orthodox insolvency law affords greater rights to secured creditors and it would be bold legislation if secured creditors are treated in the same manner as unsecured creditors.
• Related party voting. Will related party creditors be excluded from voting? As a matter of fairness for ordinary creditors, related party creditors should be excluded from voting to ensure that business insiders (such as company directors or business owners, relatives of directors, and related companies) cannot unfairly influence a positive vote against the wishes of ordinary creditors. At the very least, ordinary creditors should vote in a separate class to related party creditors, if there is to be class voting.
• Guarantees. Will creditors be able to take enforcement action against guarantors of debts subject to the scheme during the moratorium? Unless enforcement action against guarantors is also stayed, unhappy creditors could take legal action against a guarantor as a way around the moratorium.

How does business debt hibernation compare to other company insolvency procedures?

The business debt hibernation scheme has some of the features of a creditors’ compromise under Part 14 of the CA and of a voluntary administration under Part 15A of the CA. However, unlike a creditors’ compromise or a voluntary administration, the only relief (in the absence of creditor agreement) available to a company will be a six-month moratorium on the enforcement of debts. We set out below a table comparing the differences between business debt hibernation, a creditors’ compromise, and voluntary administration.

Is the business debt hibernation scheme right for my business?

The business debt hibernation scheme will be appropriate for businesses where the underlying business and future profitability is sound, but the business is experiencing short term cashflow issues due to the COVID-19 downturn.

A small business with a few creditors might be better off informally talking to its creditors in the first instance. If all creditors are supportive and agree to forbearing their debts, informal agreements would be a better solution than entry into the formal hibernation scheme. Entry into any formal hibernation or insolvency process will probably have an adverse effect on a business’s long-term credit rating. The scheme will be helpful for businesses where most creditors support hibernation, but one or more creditors are ‘playing hardball’ and insisting on immediate payment of their debt(s).

Businesses looking to gain creditor support for entry into the scheme will need to be candid and upfront with creditors as to their financial position. Most creditors will also be experiencing cashflow issues and pain due to the current economic downturn. Creditors will expect directors or business owners to have a business plan for repaying debt and getting back to business as usual. If a business can pay some of its debts during the next six months, creditors are more likely to agree to entry into the scheme if instalment payments are offered. Similarly, a business need not include all creditors in any hibernation. A business could settle certain debts, such as its smaller supplier accounts and only hibernate larger debts. 

The scheme will not be right for businesses that will be unable to pay creditors at the end of the six-month hibernation window. Similarly, the scheme will not be right for businesses that have problems with their underlying business model that cannot be turned around within the next six-months or for businesses with long-term profitability problems. In these circumstances, a formal creditors’ compromise or a voluntary administration might be better options.

We recommend that struggling directors or business owners seek professional advice before considering entry into the business debt hibernation scheme or any insolvency procedure. If you are concerned about your obligations as a director or about the future of your business, please get in touch with the authors of this article, who can advise you on your options.