Safe harbour: A potential lifeline for retail in the New Year

01 February 2018 by Peter Krejci

2018 looks set to be a competitive retail environment. Retailers facing financial distress will be able to avail themselves of recently introduced safe harbour laws in formulating a strategic turnaround plan for the business. To benefit from the safe harbour laws, directors will need to comply even more rigorously with some requirements than would be the case for a solvent company.
Oroton entering voluntary administration (VA) in early December 2017; intense media coverage of Amazon’s launch in Australia and its predicted impact on local retailers; media reports of major retailer Myer’s poor Christmas sales; a forecast drop in consumer spending due to softening house prices; these all point to troubled waters ahead for retailers leading into 2018.
As well as these strong concerns for the sector, the recent sale of the international operations of Westfield by the Lowy family to a European firm is also an indication of an outlook for the retail sector in the New Year.
As many readers will be aware, retail market conditions can be a challenge even at the best of times; they continue to be so, owing to the structural changes faced by the sector from online retail and related services.
Many industry observers and pundits predict that a number of retailers will experience financial distress brought about by the rapidly changing retail market conditions moving into 2018 and beyond. While a number of market participants will adapt, it is forecast that many others will either close or be forced into VA, as was the experience in several major cases in the US after Amazon formally launched there.
Faced with this distress, some businesses will have a balance sheet sufficient to fund trading losses in the short term, however destruction of shareholder value is never received well unless there is a strategic plan to stem the losses and bring the business back to viability, that is, via restructuring or turn around management.
The unique retail restructuring experience
In general, there are four main drivers of cost in retail:
  • cost of stock
  • labour
  • rent
  • marketing and promotions
Any restructuring plan for a distressed retailer needs to find ways of combing successful optimisation of these costs in a flexible, robust, and sustainable way.
Restructuring will usually involve negotiation with representatives of key staff, landlord, supplier and marketing groups, as well as stakeholders unique to each business. Increasingly, those representatives are aware of the deteriorating position in which both they and the businesses with which they deal operate; we have observed increasing sophistication in the approaches adopted.
More than ever, it is necessary to be able to demonstrate commitment and capacity to restructure: no stakeholder is likely to accept tentative or ambiguous plans. 
Safe harbour: A refuge for retailers?
In this environment retailers may be able to avail themselves of recently introduced safe harbour laws in formulating a strategic turnaround plan for the business, while at the same time affording the board of directors protection from an insolvent trading liability, should the turnaround plan not come to pass.
In summary, the safe harbour legislation was introduced to address the problems for directors that arise when they learn about their company’s financial difficulties. The legislation provides for a ‘breathing space’ during which directors, with the assistance of professional external advisers, are able to work through a plan or plans for the turnaround of the company.
The breathing space is not ‘carte blanche’. To benefit from the safe harbour laws, directors will need to comply even more rigorously with some requirements than would be the case for a solvent company. Those requirements will include the lodgement of activity statements and adherence to principles of proper corporate governance.
The aim of safe harbour is to allow both directors, and equally as importantly, those who are advising and funding them (for example, bankers, ‘angel investors’ or shareholders), to respond responsibly but assertively to a company’s difficulties, instead of reaching for immediate means of limiting the directors’ liability.
The stated reasons for the reform are reflected in the following comments made by those close to the policy:
‘This will drive cultural change amongst directors by encouraging them to keep control of their company, engage early with possible insolvency and take reasonable risks to facilitate the company’s recovery instead of placing the company prematurely into VA or Liquidation.’
‘… These amendments will reduce instances of a company proceeding to a formal insolvency process prematurely and where companies do enter into particular formal insolvency procedures, they will have a better chance of being turned around or of preserving value for creditors and shareholders.’
‘This in turn will promote the preservation of enterprise value for companies, their employees and creditors, reduce the stigma of failure associated with insolvency and encourage a culture of entrepreneurship and innovation.’
To be able to enter the safe harbour period, companies and their boards need to:
  1. have a plan that is ‘reasonably likely’ to achieve a better outcome for the company than an immediate appointment of a voluntary administrator or liquidator
  2. ensure that all entitlements to employees are up to date and paid when they fall due
  3. ensure all statutory lodgements are up to date under tax law and ensuring all employee entitlement are paid up to date
How to address a DPN
After forming the view that the company in financial difficulty, the board needs to formulate a plan that is reasonably likely to lead to a better outcome for the company. To be able to use the safe harbour legislation, directors need to consider the provisions that set out what a liquidator, retrospectively, may consider relevant, including that the board is:
  • properly informing themselves of the company’s financial position
  • taking appropriate steps to prevent any misconduct by officers or employees that could adversely affect the company’s ability to pay all its debts keeping appropriate financial records consistent with the size and nature of the company
  • obtaining advice from an appropriately qualified entity who is given sufficient information to give appropriate advice
  • developing or implementing a plan for restructuring the company to improve its financial position
Safe harbour application in the retail sector
In formulating a restructuring plan, understanding the unique experience of the cost drivers of a retail business, directors of a retail operation will have regard to the following.
  1. The company’s financial position. A retailer is likely to be more than one store. In most cases, certain stores will be performing better than others and the board ought to have access to detailed management accounts that show the historical performance of each store at a granular level. The management reports ought to show key metrics for each store including:

    monthly phased sales and gross margins for each store
    sales per square metre
    number of units per transaction
    average customer spend
    stock turnover rate
    sales by category
  2. While in safe harbour, the board will need to be regularly provided with detailed accurate financial information of the business commensurate with the retailers operations and to track the performance of the operations as compared to the plan being pursued.

    It is important for the company’s directors that they have absolute confidence in the financial reports, as they will provide:

    evidence of the better outcome plan being pursued in safe harbour
    a defence to directors from an insolvent trading claim if the better outcome plan being pursued is not achieved and the company subsequently enters into VA or liquidation comfort to stakeholders that a plan is being pursued which facilitates stakeholder ‘buy in’ in order to meet the plans objectives.
  3. A better outcome. In most cases, a retail operation will be in financial distress owing to a number of reasons including the following.

    Mismanagement of balance sheet. Growing too quickly by expanding into new lines, new departments or new locations.
    Controlling expenses. Major expenses such as rent are fixed (that is, premises, permanent staff salaries, etc.) and are covered by gross margin; however failing to reduce variable expenses in a declining market will lead to distress.
    Failing to manage gross margin. As a general rule margins are dropping and reducing margins too low to compete in the market will often result in financial distress.
    Inventory turns. Inventory not turning over will often create cash-flow issues.
In formulating a plan to achieve a better outcome in safe harbour, it is likely that one or more of the points will need to be addressed as to meet the objective of achieving a better outcome for the company. Examples of initiatives include, but not limited to the following.
  • Bank standstills. Most retailers will have bank facilities secured by the bank over the company’s assets. Unless the bank enters into a standstill agreement, pursuing a better outcome plan whilst in safe harbour may be futile given that the bank will have the right to appoint an administrator or receiver and manager. Communication with the bank will be imperative to provide comfort around the Plan being pursued.
  • Rent reductions/abatements. Landlords of the various stores seeking rental abatements whilst other efforts are made to rationalise the business. Rent abatements could be temporary or permanent. Depending on the size of the retailers store footprint it may be that landlords are prepared to agree to a rental abatement on the basis that a cogent outcome plan is supported with a view of limiting store closures.
  • Inventory procurement improvements. If inventory is not turning over sufficiently then inventory procurement must be explored to unlock cash tied up in stock.
  • Store closures (controlled wind-downs). It is more than likely that there will be stores that are not performing which will be required to be closed. An analysis of each stores individual performance will quickly determine which should be closed and the impact this will have on the retailers operations.
  • Cash flow issues. Seeking better terms from suppliers may be explored in terms of cash flow relief.
Again, the take away from this should be in the requirement that ‘the company is taking advice from appropriately qualified entity’. Applying safe harbour initiatives require a reasonably high level of financial skill, and directors considering availing themselves of a safe harbour regime should ensure they choose a financial advisor with both the qualifications and experience to ensure that all issues are carefully considered and adhered to.
Time will tell how the retail sector weathers the storm, as well as how the new safe harbour amendments to the Corporations Act 2001 apply.
This Industry Insight was first published in Governance Institute magazine.