Focus: Insolvency – March 2007

On the horizon: insider and insolvent trading law reform

In brief: Two papers recently released by the Federal Government could result in reforms that will make life more difficult for insolvency practitioners. The reforms include the repeal of an exemption from the insider trading law for liquidators and bankruptcy trustees and the creation of a new defence for directors facing an insolvent trading claim. Senior Associate Matthew McLennan examines the reforms.

• Insider trading
• A new insolvent trading defence?

How does it affect you? Repealing the exemption from the existing insider trading law for liquidators and bankruptcy trustees would increase the personal exposure of insolvency practitioners and require that they consider what practices and procedures they have in place to manage that exposure. Creating a new defence to an insolvent trading claim would make it more difficult for liquidators to pursue claims against company directors.

Insider trading

Background

The insider trading law under Part 7.10 of the Corporations Act 2001 (Cth) prohibits a person who is in possession of price-sensitive information about securities and other financial products from trading in them. There are three particular forms of prohibited trading: dealing (where the insider buys or sells), procuring (where the insider arranges for someone else to buy or sell) and tipping (where the insider communicates the inside information to a person likely to deal or procure). A person may be guilty of insider trading even if they did not intend to profit from the use of inside information.

A liquidator, receiver, voluntary administrator, or trustee in bankruptcy (who, for convenience, we will refer to as an external administrator) who deals, procures or tips while in possession of inside information may be guilty of insider trading. An external administrator must also consider whether an employee of an insolvent business, or one of the administrator's own employees, is in possession of inside information. If that is the case, trading by the business or the administrator may be unlawful unless the person who decided to trade was separated by a 'Chinese wall' from the employee in possession of the inside information.

In order to avoid breaking the law in these circumstances, an external administrator may refrain from trading or disclose the inside information. Disclosure will often be the easiest solution but it will not work when the external administrator is constrained by a confidentiality obligation. In such cases, the external administrator must simply refrain from trading. Such inaction is, however, inconsistent with one of the primary duties of most external administrators: to realise assets so that the proceeds may be distributed to creditors.

The existing exemption

The existing law provides some relief from this dilemma for some external administrators. Regulation 9.12.01 of the Corporations Regulations 2001 (Cth) provides that the prohibition on dealing and procuring (but not the prohibition on tipping) does not have effect in relation to a person holding the office of liquidator or trustee under Parts IV, X, XI of the Bankruptcy Act 1966 (Cth), provided the relevant transaction is entered into by the person in good faith in the performance of the functions of the office.

The exemption applies only to liquidators and bankruptcy trustees. It is does not apply to voluntary administrators or receivers.

There is no case law on what it means to enter in good faith into a transaction that might constitute insider trading. It must at least mean that the liquidator or trustee not make a personal profit from the trading and may also require that the liquidator or trustee not intend to take advantage of the inside information to make a better deal.

The CAMAC proposal

In November 2003, the Corporations and Markets Advisory Committee (CAMAC) recommended a number of changes to the insider trading law. One of the recommendations was that the exemption for liquidators and trustees be repealed. CAMAC's view was that it was unfair for the interests of the insolvent estate to be given priority over the interests of other market participants who are trading in ignorance of the inside information. CAMAC also considered that the exemption was inconsistent with an efficient market.

The Federal Government's response

On 2 March 2007, the Parliamentary Secretary to the Treasurer released for public comment a position and consultation paper responding to the CAMAC recommendations. The Federal Government's paper adopts the majority of CAMAC's recommendations, but expresses reservations about the repeal of the exemption for liquidators and trustees. The paper states:

...consideration of this recommendation would appear to involve weighing up the disadvantages of removing the exemption against the perceived increase in market efficiency and fairness for counterparties... It is desirable that people in such capacities [liquidators and trustees in bankruptcy] be able to complete their tasks, even if they have come into possession of inside information while performing them. It is undesirable that estates not be wound up or liquidations completed because the trustee or liquidator has received inside information.

In light of these concerns, the Government has called for submissions by 2 June 2007 on the following issues.

• What would be the effect of adopting CAMAC's recommendation on the willingness and ability of liquidators and bankruptcy trustees to perform their roles and on the cost of external administrations?
• What is the evidence of external administrators disadvantaging counterparties by using the exemption?
• If the exemption is to be retained, should it be subject to conditions or limitations other than, or as well as, the current requirement that the transaction be in good faith and in the exercise of official powers? 

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A new insolvent trading defence?

Iste On 5 March 2007, the Federal Treasurer Peter Costello released a consultation paper entitled Review of Sanctions in Corporate Law. The paper is concerned with the effect on commercial decision-making of the current system of sanctions for corporate wrongdoing. One of the approaches to reform considered in the paper involves refining the underlying offence provisions to identify more clearly the circumstances in which a sanction may be imposed on a decision-maker such as a company director.

The principal concern here appears to be to strike a balance between discouraging undesirable behaviour and ensuring that business is willing to take sensible commercial risks. Of the possible changes explored in the paper, the most significant would be the introduction of a general defence for directors where they act in good faith, within the scope of the company's business, and for the company's benefit.

The paper raises the issue of whether this general defence should be extended to apply to insolvent trading. Section 588G of the Corporations Act imposes a duty on directors to prevent insolvent trading by the company. Section 588H contains a number of defences, including:

• the director had reasonable grounds to expect that the company was and would remain solvent;
• the director acted on information that the company was and would remain solvent and that information was provided by a competent and reliable person;
• the director did not take part in management of the company because of illness or for some other good reason; and
• the director took all reasonable steps to prevent the company from incurring the debt.

The Government's paper does not explore precisely how the scope of the proposed good faith defence would differ from the scope of these existing defences. It notes one view that the proposed defence would make no difference because a director who could not rely on the existing defences could not be said to be acting in good faith. On the other hand, the paper suggests that many directors who take risks when their company is close to financial insolvency do so in the genuine belief that by taking the appropriate investment or other decision the company may be able to trade out of its financial difficulties. It appears to be the possibility that such directors cannot rely on the s588H defences that is motivating the Government to raise the issue for discussion. It has called for submissions by 1 June 2007.

The paper is only an early step towards law reform. If the proposed new defence is adopted, however, it seems inevitable that the increased protection for directors will make it more difficult for liquidators to bring claims for insolvent trading. 

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