Corporate debt contagion must be stopped

Company directors have welcomed the government’s coronavirus relief package. Company creditors may be a bit less enthusiastic (insert understatement emoji here).

A major aim of the relief measures is to keep money flowing through the economy. However, there is a potentially huge and catastrophic sting in the tail for creditors who receive payments from their debtors during this troubled time.

Once things have got back to normal, those creditors may be forced to return those payments, through the operation of the voidable preference laws. That may, in turn, spark a new epidemic of business collapses.

The current law works like this. If a company pays its creditors just before it goes into external administration, its liquidator can force the creditors to repay that money. A creditor’s only real defence is that, before payment was received, there were no reasonable grounds to suspect that the company was on the brink of insolvency.

In normal times, many creditors can make a decent fist of arguing that there were no reasonable grounds to suspect insolvency. In the current situation, there will be very few creditors in that position.

What should creditors do when faced with this problem? With their own creditors knocking at the door for payment, many will be tempted to take the money and run. They will then be able to pay enough of their own debts to keep their business – and employees – financially afloat.

A short way down the track, they may find themselves defenceless when the original debtor’s liquidator comes knocking. Still financially weakened by coronavirus, many creditors forced to repay voidable preferences will be themselves driven into liquidation. This will have major downstream effects once their liquidators start their own voidable preference clawbacks, driving even more businesses into liquidation.

“In normal times, many creditors can make a decent fist of arguing that there were no reasonable grounds to suspect insolvency. In the current situation, there will be very few creditors in that position.”

Laws should be suspended

The government’s recently announced package of coronavirus relief for companies does not address this issue. It suspends the long-standing prohibition on the incurring of debts by directors of insolvent companies (the so-called insolvent trading laws). This will encourage companies to stay in business despite what would be, in ordinary circumstances, terminally serious financial strains.

But there is no corresponding protection for creditors who receive payments from those companies.

Just before the coronavirus storm broke, we argued in these pages that the voidable preference laws needed to be severely pruned back. We hoped to kick off a debate that would ultimately lead to law reform.

Events have overtaken us, and the time for debate has passed. If the coronavirus is sufficient reason for immediately suspending the insolvent trading laws, a suspension of the voidable preference laws is similarly justified. The objective is the same in both cases: keeping businesses afloat and money flowing through the economy. The suspension would protect both Australian businesses and their employees.

Many of the arguments we originally advanced in support of winding back voidable preferences are, if anything, even more relevant now.

We pointed out that, in a lot of cases, the only significant beneficiaries of successful preference clawbacks are liquidators themselves, since the money recovered is used to pay their expenses. Given the potential knock-on effects of clawbacks sparked by the coronavirus crisis, leaving the law unchanged will therefore simply result in a causal chain of liquidations that provide no benefit to businesses or to the economy generally.

Changing the law immediately should be relatively simple. The relevant provisions of the Corporations Act are self-contained, and it would be straightforward to draft a provision exempting payments made during the coronavirus crisis (as has already been done with insolvent trading). This would immediately allow businesses to accept debt payments without having to worry about being punished down the track.

In our original proposal, we noted there is a strong case for keeping voidable transaction laws that target improper business practices such as payments to directors’ families and friends, and “phoenix company” activities. The unfair preference regime is not needed to target this conduct.

Our original proposals engendered both strong support and some opposition. The unfair preference regime is not needed to target this.