2021 Litigation Forecast - Insolvency: A seismically loaded fault line

2020 was a Jekyll and Hyde year for insolvency, both for New Zealand and our closest neighbour, Australia.

In our 2019 Litigation Forecast, we said 2020 would see two significant senior court decisions on directors’ duties engaged on insolvency.

  • As predicted, the Supreme Court’s decision in Debut Homes was released in late September. It sent shockwaves through the director community.
  • Originally scheduled for April 2020, the Court of Appeal only heard the Mainzeal appeal in late July and its decision remains pending at the date of writing.

Otherwise, a relatively ordinary year was expected. We obviously did not foresee the onset of a global pandemic and the lockdowns imposed in response. The first lockdown caused substantial uncertainty for directors of businesses suddenly starved of revenue. Confronted with a liquidity crisis, directors were unable to assess how the unique circumstances facing them might unfold. As a consequence, most were unable to prepare forecasts and plans on which they could rely to make the informed decisions the law required for continuing to trade businesses experiencing financial distress. The lockdown’s impact foreshadowed carnage across the economy and at the time, large numbers of insolvencies seemed inevitable. With borders shut and the population effectively on home detention, tourism and hospitality businesses were particularly hard hit. Things looked very bleak.

The year panned out very differently than presaged by March and April’s lockdown.

But the year panned out very differently than presaged by March and April’s lockdown. The economy exhibited remarkable resilience and the anticipated wave of formal insolvency appointments did not eventuate. Liquidations for the year to November 2020 were 23% down on the same period in 20191. While appointments as receivers and voluntary administrators were up over the same period (by 21% for receiverships and 7% for voluntary administrations)2, generally these appointments concerned businesses that were already experiencing financial distress prior to the onset of COVID. In contrast to what we saw following the Global Financial Crisis, initial concern about lack of liquidity was supplanted by an abundance of cash and availability of investment capital.

Much of the credit for this is due to the fiscal and monetary policy tools deployed by the Government and the Reserve Bank. Headlining these were the wage subsidy scheme, cuts to the OCR and quantitative easing. Banks also chipped in through assistance to affected businesses and individuals, including waivers and indulgences around covenants and covenant testing and the mortgage deferral scheme. Liquidity was further helped by redeployment of funds intended to be spent on overseas travel to domestic tourism and consumer spending.

Specific legislation was enacted to assist. In particular, a number of measures were introduced by the COVID-19 Response (Further Management Measures) Legislation Act 2020. Notable among these were a temporary safe harbour from application of insolvency related directors’ duties for directors of COVID-19 impacted businesses and the Business Debt Hibernation scheme (or BDH). For more detail on these and other measures introduced, see our release Government issues relief for directors and companies from insolvency provisions in the Companies Act 1993. In summary:

  • The safe harbour gave comfort to directors trading on qualifying businesses in uncertain times provided certain criteria were met; and
  • BDH provided cash flow relief for a range of qualifying trading enterprises by preventing creditor action for a month or, with creditor approval, up to seven months. While not itself providing a permanent answer to a financially distressed business, BDH was intended to allow a breathing space to either return to ordinary trading or for more traditional, substantive restructuring processes to be deployed.

The temporary safe harbour regime expired on 30 September 2020. However, BDH, originally to expire on 24 December 2020, was, on 1 December 2020, extended to 31 October 2021. The criteria for both was a business which was able to pay its due debts as at 31 December 2019, which was experiencing significant liquidity issues as a consequence of the impact of COVID-19, and for which it was more likely than not that these could be resolved over a stipulated period. As matters transpired, BDH was relatively underutilised – as at the end of November 2020, only 43 businesses had considered it necessary to seek its protection

The Australian experience was similar to that of New Zealand.

Australia

As part of its regulatory response to the pandemic, the Australian Government introduced temporary measures concerning Australia’s insolvency laws in an effort to provide a safety net for businesses facing financial distress as a result of the pandemic. Key to these measures, in the corporate context, were:

  • a temporary increase in the threshold at which creditors can issue a statutory demand (increased to $20,000 from $2,000) on a company and the time available to companies to respond to statutory demands (increased to six months from 21 days). Although a different approach to BDH, the intent was the same – to provide affected businesses with a breathing space from creditor action; an
  • temporary relief for directors from any personal liability for trading while insolvent.

As part of its regulatory response to the pandemic, the Australian Government introduced temporary measures concerning Australia’s insolvency laws

In place from 25 March 2020 to 31 December 2020, these measures were critical to avoiding a wave of insolvencies. Formal insolvency appointments in Australia dropped in 2020 compared with 2019, by 35% for the year to October3. They were on par for the first quarter, before falling away dramatically from April 2020.

The Australian Government has announced that there will be no further extension to this temporary relief, acknowledging that the inevitable cannot be delayed indefinitely. Instead, it has chosen to legislate a significant package of permanent reforms to Australia’s insolvency laws, the largest in 30 years. These will be directed at small businesses in response to liquidity challenges faced by many due to the pandemic, and in recognition that current insolvency processes are not generally appropriate for small business insolvencies.

Under the reforms, which commenced on 1 January 2021, eligible companies (those with liabilities less than AUD1,000,000) are able to access:

  • a new formal debt restructuring process to allow a faster and less complex process to restructure existing debts and maximise their chances of survival; and
  • a new simplified liquidation pathway to allow a faster and lower cost liquidation process if restructuring is not acceptable to creditors or possible.

However, these reforms will do little to assist larger companies that have suffered significant financial distress, weathering the pandemic only through government support in the form of JobKeeper (Australia’s version of a wage subsidy scheme).

Insolvency – Outlook for 2021

Although the New Zealand economy has so far bounced back better than expected, it remains to be seen whether this represents a bullet dodged or a false dawn.

Our expectation is that there will be business casualties as the effects of stimulants such as the wage subsidy scheme and mortgage deferral scheme come to an end. We see the situation as similar to that of a seismically loaded fault line. All may seem well on the surface now, but a lot of pressure has built up and who knows when or where the ground will shake and to what extent.

But while we expect an uptick in insolvency and restructuring activity in 2021, it is unlikely to be the wave originally feared. The impact will likely be felt most by small to medium sized businesses without the resilient balance sheets and capital pathways available to those at the bigger end of town, and particularly by businesses exposed to supply chain disruption or those that rely on tourism or overseas students.

So too with Australia, which has also benefitted from economic stimulus measures and temporary legislative relief and has seen an economic rebound even better than New Zealand. The market there has so far refrained from attempting to predict the extent of business failures following the expiry of their temporary relief. Debtors, creditors and practitioners appear to be waiting for the government support to end before assessing the situation and their response.

Complicating the outlook further for New Zealand is the impact of the Supreme Court’s decision in Debut Homes and is discussed in more detail in our release Supreme Court raises the stakes for directors of distressed businesses.

Debut Homes signals little tolerance for directors who continue trading financially distressed businesses rather than pursuing formal insolvency or restructuring procedures, even though they may have best intentions for improving creditor outcomes. The decision has the potential for discouraging genuine corporate rescue efforts in circumstances where current formal processes may not be feasible: voluntary administration is too costly for many businesses and compromises under Part 14 of the Companies Act 1993 lack the protection of a moratorium against creditor action.

It remains to be seen whether the senior courts will seek to contain the impact of Debut Homes or smooth its sharper edges in future decisions. The first indication will be the Court of Appeal decision in Mainzeal.

Ultimately though, substantive legislative adjustments may be necessary to restore directors’ confidence already shaken by the extraordinary events of 2020 and/ or provide more feasible restructuring pathways. Options include:

  • a permanent safe harbour for directors generally exploring restructuring options, as exists in Australia;
  • providing the protection of a moratorium against creditor action for Part 14 Companies Act compromises; and
  • following Australia’s lead in introducing a simpler formal debt restructuring process, at least for smaller companies.

Footnotes

1. As advertised in the Gazette. Liquidations for the first quarter of 2020 (prior to lockdown) had been ahead of those for the first quarter of 2019.

2. As advertised in the Gazette. Excluding the first quarter (pre-lockdown period), receiverships were down 8% and voluntary administrations were up 33%

3. Formal insolvency appointments across Australia totalled 6,020 for the year to October 2020, compared with 9,298 for the equivalent period in 2019: Australian Insolvency Statistics (ASIC) released December 2020.

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