With a tightening market for capital, the ‘safe harbour’ protections may be critical for Australian startups and scaleups who are unsure if they can raise more capital within their current cash runway or who need to raise through debt securities like convertible notes. Relying on ‘safe harbour’ shouldn’t be seen as an admission of failure or a point of no return, but as a means to better ride out the storm.
‘A ship in harbour is safe, but that’s not what ships are built for.’ For entrepreneurs, it’s a maxim to live by. Caution keeps you safe but static; embracing risk and uncertainty is what drives innovation and business creation.
With few exceptions, startups and scaleups are always fundraising, particularly once they take on venture capital investment. Many are pre-profit for substantial periods of time (and may be encouraged to be so by investors to fuel growth). Some are pre-revenue, particularly in high tech sectors where substantial investment in R&D is required before taking a product or service to market. These companies typically have a “cash runway” – a period of time over which cash resources will be used up to fund operations and growth. The business plan of these companies usually doesn’t assume the company will start generating revenue to meet ongoing expenses before the runway ends but that it will need more capital.
Directors of Australian companies must prevent the company from continuing to trade (ie incur further debt) if it is insolvent. The test for insolvency is based on cash flow not a balance sheet. It requires looking at the company’s existing assets and projected cash flows to determine if they will be enough to meet all of the company’s debts when they fall due for payment now and in the future.
So how do directors of a capital hungry, early stage company – with a known cash runway over which its funds will be depleted – get comfortable that the company is not insolvent? The answer is they can if the company has sufficient funds to meet its debts or can, on a real and reasoned view, raise additional funds to continue to meet liabilities.
Whether an expectation of raising further funds is reasonable may be difficult even in ‘good times’ but becomes even more challenging when the market undergoes a period of disruption where investors are more risk averse, and liquidity becomes more constrained; where past investor appetite may no longer prove a reliable guide for future raises. Ultimately, these questions are only likely to be judged if the company enters administration or liquidation, when those considering the reasonableness of the directors’ actions will have the benefit of hindsight.
There may come a point where a company’s position shifts from a reasonable expectation of raising more capital without overshooting its cash runway to an insolvency or potential insolvency situation. That point will likely come earlier in a tightening market where many investors pause or are slower to deploy capital.
This shift will not always be obvious. Misplaced optimism may take a company past this shift without directors taking action. Conversely, a misplaced belief that only immediate cash resources can be taken into account in assessing solvency may see directors putting a company into administration too soon, depriving creditors and shareholders of more favourable outcomes.
The ‘safe harbour’ exception to insolvent trading liability can provide powerful protection to directors, enabling the company to explore pathways for its continued operation or which may realise value for investors, such as raising capital or an acquisition by a buyer willing to take on outstanding liabilities. These protections may in fact be necessary or advisable for the company to raise further capital, particularly if prospective investors or others willing to provide support will only provide funding by way of debt, whether through a loan or through issue of securities such as redeemable preference shares, convertible notes or SAFEs which may be ‘debt’ even if only repayable in limited situations.
‘Safe harbour’ isn’t the same as appointing an administrator, liquidator or other external controller. And the company doesn’t have to make public filings or statements to access the protection. It is available any time after directors begin to suspect that a company may become insolvent, provided the directors are developing or taking a course of action that is reasonably likely to lead to a better outcome than immediate administration or liquidation (and the company is compliant with certain other mandatory requirements). In practice, this involves the directors:
- taking advice about their proposed pathway (and testing its viability);
- documenting the actions they are taking and their rationale (and the relevant supporting information);
- ensuring the position is reviewed regularly; and
- implementing an overall governance process.
The board and management continue to run the company through this process and, importantly, the company can continue to operate.
Founders and directors should not see relying on ‘safe harbour’ as an admission of failure or a point of no return, but as a means to better ride out the storm.
Key takeaways for directors
Directors of Australian startups and scaleups should closely monitor the company’s cash flow runway and burn rate with a mind on both the company’s capital raising timetable and on the test for solvency under the Corporations Act.
Directors also need to consider the rules on insolvent trading when looking at fundraising opportunities as well as in connection with normal trading activities; some common VC fundraising structures constitute ‘debt’ under the rules.
If not already, now is the time for directors and management of startups and scaleups to familiarise themselves with the rules on insolvent trading and the application of the ‘safe harbour’ exemption, including whether and when to take steps to seek that protection. In practice, the ‘safe harbour’ exception is more likely to be available (and the outcome more likely to be successful) when steps are taken early and the company and directors have made appropriate preparation to rely on it if required.
As a rough rule of thumb (noting that every company’s circumstances are different), directors may want to consider whether it is time to avail themselves of ‘safe harbour’ protection if the company’s cash runway is 6 months or less and, before that time, should aim to be familiar with the requirements and in a position to implement them if needed.
Key principles and concepts of these rules are outlined further below but as there is some complexity to the operation of the ‘safe harbour’ exception and specific requirements that must be met, directors who wish who to take the benefit of this exception should seek specific advice on its application.
Duty to prevent insolvent trading
The duty to prevent insolvent trading arises if an Australian company incurs a debt at a time when:
- the company is insolvent or would become insolvent by incurring the debt; and
- there are reasonable grounds for suspecting that the company is insolvent or would become insolvent by incurring the debt.
If director is aware, or a reasonable person in the director’s position would be aware, that such grounds exist, the director is required to prevent the company from incurring the debt. In practical terms this may require the director to appoint administrators if there is no other pathway forward.
A holding company can also be liable for insolvent trading by its subsidiaries.
Here a ‘debt’ includes any liability to pay an amount in the future and is not limited to bank debt or other finance debt. It includes, for example, incurring liabilities to pay for goods and services (eg amounts owed to trade creditors and lease payments), tax liabilities and liabilities to staff for wages and entitlements. It also includes raising funds through loans (whether with related parties or third-party financiers) and through debt securities such as redeemable preference shares, convertible notes and Simple Agreements for Future Equity (SAFEs), even if they are only repayable in limited situations (unless they are only repayable at the company’s option). Some transactions that are typically thought of as capital-like transactions are considered incurring a ‘debt’ for these purposes such as paying a dividend and certain share redemptions, buy-backs and capital reductions.
Companies incur liabilities in day-to-day operations. So, if a company is already insolvent, a breach of this duty can arise if the company continues to trade. For this reason, it’s typically described as a duty to prevent insolvent trading.
When is a company insolvent?
The Australian Corporations Act has a specific definition of “insolvent”. Under that definition, an Australian company is insolvent if it is unable to pay all of its debts as and when they become due and payable.
A company can be insolvent even though its debts have not yet fallen due for payment. Insolvency arises at the point where there is sufficient likelihood that the company will not be able to meet its debts when they become due, not at the time when those debts actually fall due. It therefore requires consideration of the future, not merely the present.
The test for insolvency is a cash flow test, not a balance sheet test, but is not based solely on the immediate cash resources of the company. When considering its solvency, a company can include funds that it can, on a real and reasoned view, raise by the sale of assets, raising capital, secured borrowing or other reasonable means within the time period required to meet debts as they fall due.
If a company has a known remaining “cash runway” but a real and reasoned expectation of raising capital before the end of that runway, its directors may therefore be comfortable that it is not insolvent under the above test. But it will be important to continue to monitor and test that position as time passes and circumstances potentially change.
Directors should also consider, if for any reason funds are not able to be raised when expected, what evidence they would point towards to demonstrate that the capital raising was nevertheless a realistic and reasonable expectation at that time.
Consequences for directors if breached
Directors who breach this duty are at risk of civil penalty orders, including a fine of up to $1,110,000 or, if the Court can determine it, three times the amount of the benefit derived and detriment avoided because of the contravention (whichever is the greater). They are also at risk of orders to compensate the company and/or its creditors, including liability for unsecured debts incurred after the date it becomes insolvent and that remain unpaid in a liquidation. Compensation is calculated by reference to the relevant creditors’ losses; in other words, the directors may be required to cover the outstanding debts personally.
For more serious breaches (where directors have acted dishonestly), criminal penalties may also apply.
Directors may be at heightened risk of disqualification by the Australian Securities and Investments Commission from acting a director of other companies where they are found to have engaged in insolvent trading.
‘Safe harbour’ exception
Under the safe harbour exception, the duty to prevent insolvent trading does not apply if:
- at a particular time after the director starts to suspect the company may become or be insolvent, the director starts developing one or more courses of action that are reasonably likely to lead to a better outcome for the company than the immediate appointment of an administrator or liquidator; and
- the debt is incurred directly or indirectly in connection with any such course of action during the period starting after that time, and ending at the earliest of any of the following:
- if the person fails to take a course of action within a reasonable period after that time – the end of that period;
- when the person stops taking any such course of action;
- when the course of action ceases to be reasonably likely to lead to a better outcome; and
- the appointment of an administrator or liquidator.
Accordingly, safe harbour protection is available any time after the directors begin to suspect that a company is or may become insolvent. To obtain that protection the directors must ‘start developing’ a safe harbour plan being one or more courses of action which are reasonably likely to result in a better outcome – an outcome that is better for the company than the immediate appointment of the administrator or liquidator. Once a course of action is selected it protects the directors from liability for debts incurred for as long as the directors are continuing to pursue that course of action and it continues to be reasonably likely to result in a better outcome.
There are a number of specific factors that a court may have regard to when considering whether a course of action was reasonably likely to lead to a better outcome. These factors are whether the director:
- is properly informing himself or herself of the company’s financial position;
- is taking appropriate steps to prevent misconduct in the organisation that could adversely affect the company’s ability to pay all its debts;
- is taking appropriate steps to ensure the company is keeping appropriate financial records consistent with the size and nature of the company;
- is obtaining advice from an appropriately qualified entity who was given sufficient information to give appropriate advice; and
- is developing or implementing a plan for restructuring the company to improve its financial position.
However, the safe harbour protection is not available if the company is failing to pay employee entitlements when due or to comply with certain tax filing obligations (certain minor failures excepted).
Directors have an “evidentiary burden” if they wish to rely on the safe harbour. This means that directors have an initial burden of pointing to evidence that suggests a reasonable possibility that the requisite requirements of safe harbour are satisfied. It is therefore important to keep detailed records of compliance with the safe harbour requirements.
More generally, there is some complexity to the operation of the safe harbour exception. Directors who wish who to take the benefit of this exception should therefore seek specific advice on the application of the exception in preparing their safe harbour plan.
Finally, it is important to note that whilst the safe harbour exception protects directors from civil liability (including compensation claims), it does not provide protection from criminal liability should directors act dishonestly.
Defences
In addition to (or as an alternative to) the safe harbour exception, directors also have a defence to insolvent trading liability if they can prove that, at the time that the debt was incurred, the director had reasonable grounds to expect, and did expect, that the company was solvent and would remain solvent even if it incurred the debt. This expectation of solvency requires a higher degree of certainty than ‘mere hope or possibility’ or ‘suspecting’. The defence requires an actual expectation and confidence that a company is and will continue to be solvent and that the grounds for so suspecting are reasonable. Ignorance of the company’s financial position is not a defence.
Directors may also have a defence if:
- the director did not take part in management of the company for some good reason (eg illness) when the debt was incurred; or
- the director had reasonable grounds to believe (and did believe) that a “competent and reliable person” was responsible for providing to the director adequate financial information about whether the company was solvent, that person was fulfilling that responsibility, and the director expected on the basis of that information that the company was and would remain solvent (a defence that is generally more relevant for directors of larger companies who are more reliant on management reporting to the board).
For further information, please contact:
Paul Apáthy, Partner, Herbert Smith Freehills
paul.apathy@hsf.com
