Commercial contracts commonly include a term which permits one party to exercise certain contractual rights (including the right to terminate) if the other party is either insolvent or at the risk of becoming insolvent. Such clauses are commonly called “ipso facto” clauses.
Permitting counterparties to terminate key contracts based purely on insolvency events (when other contractual provisions continue to be performed) can restrict post appointment trading and reduce value for creditors. The insolvency industry has lobbied for many years for legislative intervention restricting the enforceability of such clauses.
The issue has now been addressed as part of the Treasury Laws Amendment (2017 Enterprise Incentives No.2) Act 2017 (Corporations Amendment Act) which was passed in September 2017. Part 1 of this legislation introduced a safe harbour defence for directors (in respect of insolvent trading claims), which commenced in 2017. Part 2 deals with “ipso facto” provisions and commences on 1 July 2018.
According to the Explanatory Memorandum to the Corporations Amendment Act (EM), the operation of “ipso facto” clauses can reduce the scope for a successful restructure, destroy the enterprise value of a business entering formal administration, or prevent the sale of the business as a going concern. These outcomes can “also reduce or eliminate returns in subsequent liquidation by disrupting the businesses’ contractual arrangements and destroying goodwill, potentially prejudicing other creditors and defeating the purpose of a voluntary administration”. The stay on “ipso facto” clauses introduced by the Corporations Amendment Act “assists businesses to continue to trade in order to recover from an insolvency event instead of preventing their successful rehabilitation.”
Amendments to the Corporations Act
Part 2 of the Corporations Amendment Act is titled “Stay on enforcing rights merely because of arrangements or restructures”. The Part inserts new provisions into the Corporations Act 2001 (Cth) (Corporations Act) which will apply to contracts entered into after 1 July 2018. Existing contracts entered into before 1 July 2018 will not be affected.
The new law imposes a stay under which a right (under a contract, agreement or arrangement) cannot be enforced against a corporation or company by reason of:
- the company entering administration, having a managing controller (receiver and manager) appointed or entering into or proposing a section 411 scheme of arrangement (but only where that scheme is proposed as a means of avoiding a winding up in insolvency) (collectively referred to in this paper as the “triggering insolvency events”);
- the company’s financial position if the company becomes subject to one of the triggering insolvency events;
- a reason prescribed by the regulations; or
- a reason that is, in substance, contrary to the provisions.
The stay also applies to “self executing” provisions. For example, a contractual provision imposing an automatic termination by reason of a triggering insolvency event would be unenforceable for the period of the stay.
What rights will the stay apply to?
All “rights” arising under a contract, agreement or arrangement are covered (subject to some exclusions which are discussed below), including:
- rights to terminate merely because the corporation has entered into an insolvency process;
- a right to call upon security, such as a bank guarantee;
- right to suspend services, works or the supply of goods because of the insolvency process.
Provisions permitting termination for other events where that right is in essence because of the company becoming subject to a triggering insolvency event may also be covered. This may include “material adverse event” clauses.
The right to terminate or take other steps due to most other breaches of a contract (such as non-payment of monies) should be unaffected. However, it is worth noting that the legislation contains anti-avoidance mechanisms which can extend the stay to other reasons that are in substance contrary to the new law, and capture clauses which attempt to circumvent the new law.
How long does the stay apply?
The stay will apply until the end of the triggering insolvency event or Court order. For example, if the stay commences because a receiver has been appointed, the stay will end when the receivership ends (unless some other event such as administration is also in place at that time).
Where the triggering insolvency event is the appointment of an administrator and a deed of company arrangement (DOCA) is then executed, the stay ends when the DOCA is executed. When the administration is followed by a liquidation, the stay only ends when the company’s affairs have been fully wound up. This is an odd outcome given that the purpose of the amending legislation is to assist insolvent companies going through a restructuring process. The position can be changed, however, by Court order.
The position also differs from an ordinary creditors’ voluntary liquidation or a court ordered liquidation. The appointment of a liquidator in these circumstances is not a triggering insolvency event and no stay will apply (unless, for example, a receiver and manager is also appointed).
It should be noted that while the stay will be lifted at the end of the triggering insolvency event or Court order, the relevant ipso facto clause will continue to be unenforceable to the extent that a reason for seeking to enforce that right relates to the earlier triggering insolvency event or the company’s financial position before the end of the stay period.
Is the “innocent” party obliged to continue performing during the stay?
With some key exceptions, yes.
Given the objectives of the legislation, the parties to the contract are not excused from continuing to perform their obligations under the relevant contract while the stay applies (as long as the contract remains on foot). The exceptions are obligations on the “innocent” party to make new advances of money or credit to the insolvent party. Such obligations are suspended for the duration of the stay imposed on the ipso facto clause.
Continuing obligations will come to an end obviously if the insolvent party either terminates or repudiates the contract. Otherwise, whilst the contract remains on foot, the innocent party’s right to terminate or take other steps permitted under the contract for a breach of ordinary obligations of the insolvent party (such as the payment of monies) will remain. Such rights are unaffected by the new regime unless they fall within the “anti-avoidance” provisions noted above.
Powers of Courts
The amendments give powers to Courts to both declare and order a stay (which stay is really imposed by the legislation anyway) and to lift the stay including where “this is appropriate in the interests of justice”.
What are the exceptions?
- The stay only applies where rights are exercised because of one of the triggering insolvency events listed above. These do not include the company entering liquidation.
- In the case of schemes of arrangement, the stay only applies where the scheme is to allow the company to avoid insolvency.
- The stay only applies to contracts entered into after 1 July 2018.
- The new law is unlikely to have extraterritorial effect, as the Corporations Act is restricted in its operation to Australia and its territories.
- Certain types of contracts are excluded from the stay on “ipso facto” clauses, by the Corporations Amendment (Stay on Enforcing Certain Rights) Regulations 2018 (the Regulations). An exposure draft of the Regulations was released in April 2018 and, following a public consultation process, the final version was released and registered on 22 June 2018,
The Government has also proposed to exclude certain types of contractual rights. These exclusions are contained in the draft Corporations (Stay on Enforcing Certain Rights) Declaration 2018 (Draft Declaration). The final version of the Draft Declarations has not yet been released.
Contracts excluded by the Regulations
In summary, the following types of contracts are excluded by the Regulations:
- Arrangements relating to laws, international obligations and public services – including government licences, permits or approvals, and supply of goods or services to certain public sectors
- Arrangements relating to securities and financial products – including arrangements that are derivatives or securities financing transactions, underwriting arrangements for securities, financial products, bonds, promissory notes or syndicated loans (collectively “financial products”), contracts for subscribing or procuring subscribers for financial products, rights issues by Australian companies, certain arrangements related to debt capital market transactions, margin lending facilities and issue of covered bonds
- Complex arrangements between sophisticated parties – including arrangements involving a special purpose vehicle for the provision of securitisation, a public-private partnership or project finance, arrangements for the keeping source codes or passwords in escrow and arrangements for the commercial charter of a ship
- Arrangements relating to debt and the ranking of creditors – including subordination arrangements, flawed asset arrangements and factoring arrangements
- Arrangements relating to financial markets, and clearing and settlement facilities
- Netting arrangements
- Novating and assigning rights – novating and assigning rights from pre-1 July 2018 arrangements, varying pre-1 July 2018 arrangements (only applies to renewals or novations entered into on or after 1 July 2018 but before 1 July 2023)
- Certain construction contracts entered into on or after 1 July 2018 but before 1 July 2023
- Contracts for the sale of all or part of a business
Contractual rights excluded by the Draft Declaration
In summary, the following types of contractual rights are currently excluded by the Draft Declaration:
- Uplift and indemnification clauses – i.e. financing arrangements that allow the lender to charge a higher rate of interest following a triggering insolvency event, or to enforce an indemnity for costs and expenses incurred as a result of the other party experiencing a triggering insolvency event
- Termination rights in a standstill or forbearance arrangement – i.e. rights to act on earlier defaults suspended or reserved under standstill or forbearance type arrangements, which are triggered on the occurrence of a triggering insolvency event
- Right to change the priority in which amounts are to be paid – i.e. a “flip clause” which flips the priority of payment obligations between parties
- Right of set-off and acceleration of such rights – e.g. a right of set-off, a right to net balances (or other amounts) or a right to take an action to enforce such rights
- Rights of assignment and novation
- Self-executing provisions – certain self-executing provisions are excluded from the stay in order to provide certainty around the treatment of circulating assets in insolvency and ensure that there is no conflict with the Personal Property Securities Act 2009 (Cth)
- Step-in rights – a right to perform obligations of an entity (being the entity which would have the benefit of the stay) under a contract or a right to enforce a right under a contract that would be enforceable by that entity
When drafting new contracts, should we remove any right to terminate by reason of one of the triggering events above?
While it is possible, when drafting new contracts, to preserve standard termination provisions that are triggered by insolvency events, the contracting parties must be made aware that enforcement of those rights may be restricted under the new law. If this approach is adopted, we suggest making it clear in the contract that the relevant termination rights are subject to the new law (it would be advisable to call out the specific provisions of the Corporations Act or expressly carve out rights that are subject to the stay).
A more holistic approach to manage the impact of the new law would be to consider taking one or more of the following steps, and ensure that rights which are not triggered by insolvency events do not fall through the cracks due to ineffective drafting:
- Expressly set out in the contract specific performance and payment obligations and required timeframes, and what conduct will constitute a breach of the contract;
- Clearly identify the parties’ rights to terminate or suspend the contract, in particular rights that are not based on triggering insolvency events (nor captured by the anti-avoidance provisions). This may include a right to terminate for:
- failure to perform contractual obligations or make payments within the required timeframe;
- failure to achieve key milestones in a project by set dates;
- failure to rectify defects within a prescribed time period after the date for completion;
- failure to meet the specified service levels or KPIs.
- Consider whether it is appropriate to include a right to terminate the contract for convenience.
- Where appropriate, include contractual rights that are exempted from the “ipso facto” stay, such as set-off rights and step-in rights.
- Include a right to inspect financial statements of the counterparty at any time during the contract term.
Other actions that can be taken include:
- Placing greater focus on due diligence on potential counterparties prior to entering into contractual relationships. This could include conducting relevant corporate and PPSR searches on the counterparty, and inspecting their financial records.
- Considering whether it is possible to extend an existing contract (which contains “ipso facto” clauses) entered in before 1 July 2018, rather than entering into a new agreement with the same counterparty. This is particularly as the Regulations exclude any novation or assignments of pre 1 July 2018 contracts from the legislation (if it is entered into on or after 1 July 2018 and before 1 July 2023).
What will be the impact of these provisions on insolvencies?
The new law will only apply to contracts entered into after 1 July 2018. It will therefore be some time before the legislation has much practical impact.
The actual impact may also depend on what ongoing obligations the contract imposes on the insolvent company and whether these can be met by the company. The Corporations Act imposes personal liability on both receivers and administrators in respect of certain payment obligations of insolvent companies which arise under pre appointment contracts but fall due for payment after appointment of the receiver or administrator (for example, rent under leases). Whether receivers and administrators wish to keep such contracts on foot will depend on whether the company has the available means to meet ongoing obligations.
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