Informal workouts

Introduction

Informal workout agreements can renegotiate, delay, reduce or waive pre-existing debts owed by a company. For the debtor company, the main purpose of entering into an informal workout is to obtain agreements from its creditors to relinquish rights and refrain from enforcing certain debt covenants. The following are some commonly used informal workout mechanisms:

• refinancing of debt obligations;
• debt-for-equity swaps;
• discounted debt sales;
• enterprise restructurings;
• exchange offerings; and
• debt write-offs.

To be successful, an informal workout generally requires the consent of all affected creditors. Informal workouts lack the ability to bind dissenting creditors – any creditor who declines to participate in the informal workout can still enforce its legal rights against the company.

An informal workout does not generally carry the stigma of formal insolvency procedures. Additionally, the publicity involved with formal insolvencies can be destructive of the value of a company's goodwill and its standing in the market, thus aggravating the company's financial difficulties.

These considerations have formed part of the argument for a legislative regime in Australia which supports initiatives to restructure companies otherwise than by way of formal procedures.

A barrier to such initiatives is a provision of Australia's Corporations Act (CA), which imposes a duty on directors to prevent insolvent trading.¹ In essence, where:

(a) a company incurs a debt;

(b) it is insolvent;

(c) there are grounds to suspect its insolvency; and

(d) the company goes into liquidation,

a director can be liable to compensate the company for the loss it has suffered as a result of the debt being incurred.

Fear of falling foul of insolvent trading prohibitions can be a major deterrent to a company director and a key reason for unwillingness to take any risks around insolvency. Holding companies can also be liable for the losses incurred by their subsidiaries as a result of holding the company incurring debts while insolvent.²

The response to this argument has been the adoption of a "safe harbour". This can operate as a defence to an insolvent trading claim, and is available for both the directors of a company and, where relevant, its holding company.³

Essentially, actions taken by a director whose company may otherwise fall into insolvent trading, may be permissible under safe harbour. This can allow directors to take actions – in particular, incurring further debt – which may ultimately save the company, but with less personal risk to themselves.

Safe-harbour defence

The defence of safe harbour is available where:

(a) a director starts to suspect that the company may become or be insolvent;

(b) the director starts to develop one or more courses of action;

(c) such actions are reasonably likely to lead to a better outcome for the company; and

(d) the debt is incurred directly or indirectly in connection with one of those courses of action.