COVID-19 Insolvency law relief: What’s in the Bill, and how to use it

The package forms part of the COVID-19 Response (Further Management Measures) Legislation Bill that was introduced yesterday afternoon. The Bill is expected to be progressed quickly, with Parliament's Epidemic Response Committee expected to report on the Bill by next Tuesday, 12 May 2020.

The Bill is broad in scope and amends or modifies some 45 different pieces of legislation. In this update we focus on two of the proposed changes to the Companies Act 1993: relief from directors' duties and a new business debt hibernation scheme. We then outline when and how directors might make use of them.

Directors' duties relief

The Bill proposes significant, but temporary amendments to the two directors' duties that apply specifically to insolvency scenarios:

the duty not to trade recklessly, and
the duty not to allow the company to incur obligations without a reasonable belief that they will be met when due.

Together, these duties protect the interests of the company's existing creditors. They also protect the interests of new creditors that may arise from ongoing trading. Effectively, the duties prohibit directors from taking unreasonable business risks at the expense of creditors who will not be paid.

Many directors were concerned that they would breach these duties by continuing to trade through the uncertainty created by the COVID-19 crisis. The Bill addresses that by providing a safe-harbour for directors of companies affected by COVID-19. It provides that, for most companies,¹ directors' decisions to continue to trade, and to incur new obligations, will not breach the duties set out above for the period between 3 April 2020 and 30 September 2020 (or such later date as is set by regulations) if the directors can establish that:

No prior issues: The company was either:
1. able to pay its debts as they fell due on 31 December 2019, or
2. formed between 1 January 2020 and 25 March 2020,
COVID-19 is causing liquidity problems: In the good faith opinion of the directors, the company is facing or is likely to face significant liquidity problems in the next six months as a result of the effects of COVID-19 on the company, their creditors, or their debtors, and
The company will be solvent by 30 September 2021: The directors, in good faith, consider that it is more likely than not that the company will be able to pay its debts as they fall due by 30 September 2021 (for example, because trading conditions will improve or they will reach a compromise with creditors).

Business debt hibernation (BDH) scheme

Even if it would be consistent with a director's duties to continue to trade, ongoing trading may not be possible if the company lacks the liquidity needed to pay its bills during the COVID-19 crisis. Creditors have a legitimate interest in being paid, and in many cases will need to be paid in order to avoid liquidity shortfalls of their own.

In the Bill, the government has attempted to balance those interests against the benefit of providing a pathway for otherwise profitable businesses to re-open once the crisis passes with a BDH scheme. Until 24 December 2020, most companies,² partnerships, and other trading entities will be able to propose to creditors that most³ debts of the business should be put into a form of “hibernation" for up to six months. The BDH scheme will be available to entities that were able to pay their debts when due as at 31 December 2019, as long as 80% of the directors vote in favour of the decision to enter into BDH, and those directors sign statutory declarations that it is their good faith opinion that the factors listed 1 - 3 above apply. Any creditor may require the directors to renew the statutory declarations during the moratorium period (though not more than once every two months).

If a BDH proposal is made by an entity:

One-month protection period: There will be a one-month protection period on the enforcement of debts from the date the proposal is notified to the Registrar of Companies, and
Six-month protection period if the proposal is approved: There will be a further six-month protection period if the proposal is passed by creditors.

In order to be binding, the proposal must be approved by 50% of creditors, including secured creditors, in both number and value. Creditors will vote as a whole, rather than being separated into different classes. Related-party creditors may not vote (unless the Court orders otherwise).

The proposed protections are extensive. They include:

An extensive moratorium, including for most secured creditors: For the initial moratorium period, it will prevent most secured creditors (other than General Security Agreement holders) from enforcing mortgages or other security interests (unless they have already begun to do so, or the collateral is perishable), owners or lessors from recovering their property, and creditors from taking or continuing any litigation or enforcement processes. GSA-holders are in a different position. GSA holders can enforce their charge at any time, and are only restricted in using other rights during the first part of the protection period, before the creditors vote.
A restriction on enforcing related-party guarantees: Subject to orders of the Court, creditors (apart from GSA-holders) will also be prevented from enforcing guarantees against any director or shareholder, or their relatives. Other guarantees, including by banks or other related entities, will not be affected.
Voidable transaction protection: Transactions entered into in good faith and on arms-length terms during the protection period will not be subject to the voidable transaction or prejudicial disposition regimes that can otherwise unwind transactions in the period before insolvency.

Compromise proposals under this regime may defer or reduce payments made during the protection period, but cannot permanently cancel or reduce any amount owing. Any more substantial compromises, involving broader restructurings or reductions in debt, will need to be proposed under one of the other compromise or arrangement regimes available in the Act (as set out below).

How do the reforms sit with existing processes?

The changes in the Bill reflect the fact that none of New Zealand's existing insolvency processes provide an effective “standstill" mechanism for companies with short term liquidity problems. They will sit alongside the existing regimes, including voluntary administrations, creditors' compromises, schemes of arrangements, and private arrangements:

Voluntary administration: Like the BDH regime, voluntary administration is an option for a business that has solvency problems, but is capable of being rescued. If a company is insolvent or becoming insolvent, a voluntary administrator can be appointed under part 15A of the Companies Act 1993. The voluntary administrator will take control of the company, and consider whether an arrangement can be put to some or all creditors, which, if passed by a majority in number representing 75% in value of the creditors, becomes binding on the creditors. This regime has the advantage of a moratorium, and removes any risk to directors for trading during the administration period. However, it involves the administrators taking control of the company from the directors, can end in liquidation if no arrangement is agreed, and requires a higher threshold (75% by value) to adopt an arrangement.
Creditors' compromise: Creditors of a company can already implement binding compromise arrangements, by agreement of each affected class of creditors (if approved by 50% in number and 75% in value of each affected class). The existing compromise regime allows for much more extensive restructurings, including modifications of the terms of debt, or amounts owing to creditors. Compromises can be approved by postal vote, without involving the Court, and as such can be an effective process for companies at risk of insolvency.
Scheme of arrangement: The Court has a very broad discretion to approve schemes of arrangement that can change or limit the rights of both shareholders and creditors. It will only exercise these powers if, after making appropriate disclosures, each class of affected shareholders or creditors approves the scheme by a 75% vote. Control of the company remains with the directors throughout this process. This is a powerful tool for implementing complex restructures, but the need for full disclosure and Court approval and detailed disclosure can mean that it takes longer to implement, which can pose additional risks for directors of an insolvent business.
Private arrangements: Finally, of course, directors may not need any of these mechanisms to reach an agreement with their creditors. In many cases, it will be possible to simply agree the necessary arrangements.

Practical tips: how to use the new insolvency relief

The new provisions provide directors with significant comfort about short-term liquidity problems caused by COVID-19. The key questions for directors will be:

Was the company able to pay debts on 31 December 2019? Directors must make a realistic assessment of this, because it is a gateway issue for both of the proposed reforms. In the case of the safe-harbour provision, the test is objective: if the Court concludes that the company could not pay its debts on 31 December 2019 then the safe-harbour provisions will not apply, regardless of what the directors believed.
Will the company be able to pay the debts by 30 September 2021? Directors will need to make a good faith attempt at a realistic assessment of this question. Given the inherent uncertainties involved, this will mean directors need to make assumptions about things like the state of the economy between now and 30 September 2021, and their extent of their business' recovery by then. The assumptions involved in that assessment will need to be reasonable in the circumstances, which may involve directors seeking advice, from within the business or from external advisers. However they form their view, directors should document the reasons for their decision.
What is in the best interests of the company and its creditors? Directors will need to make a robust assessment of whether it is in the interests of creditors and shareholders to continue, and, if so, what interim measures are best suited for the business. The new BDH regime contains strong short-term protections for companies that need only to outlast the immediate COVID-19 trading restrictions, but carries risks for directors that engage it without a proper basis, and is less flexible or powerful than the restructuring regimes already in the Companies Act.
Do the directors wish to remain in control of the company during the COVID-19 crisis? Generally the answer to this question will be “yes", in which case the BDH regime (or creditors' compromise or scheme of arrangement) will be suitable. But if the risk of continuing is too high, for example because the company was insolvent at 31 December 2019 or a BDH compromise led by the directors is not possible, then voluntary administration might be the better option.

The new regime is intended to strike a balance between protecting creditors' rights, and allowing directors to keep their business open (albeit with debts in hibernation) through the COVID-19 crisis. This means that directors need to act quickly, and keep creditors' interests top of mind. In particular:

Directors will bear the burden of proof: Directors will bear the burden of proof with the safe-harbour provisions. This highlights the need for directors to maintain good contemporaneous records of their decision-making, especially if they anticipate needing to rely on the new safe-harbour provisions.
Good faith is key: The safe-harbour provisions are only available to directors that have made good faith assessments as to the company's future solvency. There is a risk of some directors not giving this requirement the attention it deserves, especially they are unaccustomed to having their good faith questioned. Directors should specifically record the basis of their good faith assessment of the company's solvency.
Duty to consider the interests of creditors: The proposed changes do not affect the directors' duties to exercise powers in what they believe to the best interests of the company. While the company is insolvent or near insolvency, this means that the directors need to take account of the interests of creditors. The regime is not a license to take unreasonable risks with creditors' money. If directors are diligent about the gateway requirements for the safe-harbour provisions and the BDH scheme then they are likely also to have complied with their duty to consider the interests of creditors, but it would be prudent for directors to give the matter separate consideration.
Duty to act with reasonable care: Directors must continue to exercise reasonable skill, care, and diligence.
Duties are unaffected for companies that were already insolvent: The directors' duties relief is only available for businesses that could pay their debts as they fall due on 31 December 2019. Directors of companies that were already struggling will not have the benefit of the changes, even if COVID-19 has made the final difference for the company.
Enforcement processes otherwise unaffected: Unless and until a BDH proposal is made (or a voluntary administrator or liquidator is appointed), creditors are entitled to enforce their debts as normal. Unlike the position in Australia, the government has not proposed any changes to the tight deadlines for statutory demands.
Criminal offences not affected: Serious breaches of directors' duties can lead to criminal liability. For example, it is a crime for a director to dishonestly fail to prevent a company incurring a debt when the director knows that the company is insolvent. Directors are unlikely to commit that offence (and others) if they genuinely believe that it was lawful to incur the debt because of the new relief provisions, but it does highlight that the new provisions do not provide directors with a carte blanche authority to trade while insolvent.
Watch for Regulations: The Bill allows for Regulations to be made to extend the time periods in the Act, or limit its application. Directors would be well advised to monitor any Regulations that might affect how the Act will apply to their business.

Whichever option is preferred, directors ought to act promptly to make a realistic assessment of their position, and engage early with creditors. Our experience is that many businesses are able to maintain good relationships with their stakeholders, and negotiate the support needed to outlast the COVID-19 crisis.

Creditors who are concerned that they may not be paid as a result of COVID-19 would also be well-advised to make early contact with their debtors. Their key considerations are likely to be:

Are my security interests properly perfected? As always, it is important for creditors to ensure that their security interests are properly protected, including in the case of personal property by having them perfected in terms of the Personal Property Securities Act 1999.
Will early enforcement help, or hurt? Creditors will need to form a view on whether enforcement action is likely to lead to a better result than forbearance, or agreeing to a BDH proposal. On one hand, early enforcement may carry reputational consequences, and may lead to a worse outcome than if the company is given time to regroup. On the other hand, sometimes assertive action is the only way to generate payment. Further, most secured creditors (apart from GSA-holders) can only continue enforcement action they have started when an entity makes a BDH proposal, so will need to act promptly if they wish to enforce.
Are my security interests affected by the BDH scheme? Creditors with security interests (apart from GSA-holders) will not be able to commence enforcement during a BDH period unless they apply to court or are allowed to under the BDH arrangement. Trade creditors should insist that the BDH arrangement set out when and how they may enforce their security or otherwise collect debts, as a condition of voting for the BDH proposal and continuing to supply the business. They should ensure they are able to enforce their security interests immediately if a GSA holder appoints receivers.

If you would like to discuss these options or any associated issues, please contact the authors or your usual Bell Gully adviser.

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¹ The safe-harbours will not apply to specific types of companies, including registered banks, licensed insurers, non-bank deposit takes, and others.
² The new regime will also not apply to banks, insurers, and others. It will also not apply to companies in liquidation, VA, subject to a DOCA, in statutory management, or receivership.
³ The BDH regime will not apply to most payments to employees (including salary and wages), and certain other excluded debts.

Disclaimer
This publication is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.