When terminating for an insolvency event is no longer an option
Following the implementation of the Safe Harbour protections introduced last September, new changes to the Corporations Act 2001 come into force on 1 July 2018, significantly limiting the ability of parties to rely on insolvency as a means to terminate a contract. These changes intend to help facilitate the restructure and turnaround of struggling companies and are being hailed by insolvency practitioners as a long overdue softening of existing insolvency laws. However, businesses should be aware of the implications of these changes and take steps, where possible, to mitigate their risk.
In this article, Andrew Clark of Moulis Legal explores the reasoning behind the changes, their practical consequences for businesses and the steps that should be taken to limit adverse exposure.
The right to terminate and/or modify a contract on the occurrence of an insolvency event is a common provision in almost all contracts that create ongoing obligations between parties. This clause, known in legal speak as an ipso facto clause (meaning by that very fact), creates an automatic right on the happening of a defined event (for example the appointment of an administrator), to ether terminate the contract or trigger enhanced rights in favour of the solvent party. These enhanced rights often include the right to call upon a guarantee, security or retention, invoke set-off rights, suspend performance, step into the contract, or engage a third party to perform the relevant obligations. The right is triggered regardless of the counterparty’s continued performance of its obligations under the contract. Under the changes to come into effect on 1 July 2018, the enforcement of ipso facto clauses will be prohibited except in limited circumstances.
The reasons behind the changes
The lack of protection from the operation of ipso facto clauses has been a key criticism of Australia’s insolvency regime in the past and the changes will bring Australia more into line with the US position where ipso facto clauses are typically unenforceable during the course of the bankruptcy process. The intended consequences of the reforms are twofold:
- to further promote a culture of entrepreneurship and innovation to help drive business growth; and
- to assist businesses that are struggling financially to continue trading for longer, giving them more opportunity to trade through difficulties, restructure, or be sold as a going concern.
The operation of an ipso facto clause will often reduce the likelihood of a successful restructure and significantly damage the goodwill of a business, which in turn makes the sale of the business as a going concern much less likely. This then has the effect of prejudicing other creditors and can make a board reticent to enter into voluntary administration as a means to turnaround the fortunes of the business.
The changes are part of a broader program to improve bankruptcy and insolvency laws with the aim of encouraging restructure and turnaround, and follow on from the safe harbour regime which came into force in September 2017. Under the terms of that regime, directors are now offered greater protection from a claim of trading whilst insolvent where they can establish that they are taking a course of action reasonably likely to lead to a better outcome for the company. The stay on enforcement of ipso facto clauses will further strengthen a director’s ability to trade out of difficult times.
The new prohibitions will only apply to contracts entered into after the new provisions come into effect. The stay falls away if and when the party goes into receivership or liquidation, and can otherwise only be lifted on application to the Federal Court.
From a practical perspective, businesses should assess existing template and precedent contracts and consider the consequences of the new provisions. Noting that termination for non-performance or failure to pay is not affected by the changes, businesses should review other termination options and consider whether these need to be strengthened. Where possible, including a termination for convenience clause (for example a right to terminate on 30 days’ notice) would give the business the same protection as an ipso facto clause although it is recognised that such a provision is not likely to be acceptable in many contracts. Broadly-drafted material adverse change provisions may also prove helpful, but should be carefully considered so as not to be caught by relevant anti-avoidance provisions.
Where contracts come up for extension or renewal, or are to be novated to a new party, these contracts should also be reviewed in light of the changes. Any extension, renewal, or novation is likely to be treated as a new contract and subject to the new restrictions. The opportunity should therefore be taken to refresh counterparty financial information and consider whether additional protections are necessary.
In addition, businesses should re-assess the amount and types of security that are requested under their contracts and should take pro-active risk management steps to evaluate the financial standing of their counterparties.
Finally, if an insolvency event occurs with respect to a counterparty, parties should get further advice before attempting to enforce any ipso facto clause or otherwise terminating or modifying the contract. Terminating in breach of the new provisions may exacerbate an already precarious relationship and create an unwanted future claim for damages.
There will be a number of exemptions to the stay. Whilst full details of these are currently being finalised, they will focus on specific types of contracts exempted by regulation, contracts that manage financial risk or relate to financial products where such clauses are commercially necessary, contracts where an established market mechanism already exists, and a limited number of other commercially necessary situations.
This article presents an overview and commentary of the subject matter. It is not provided in the context of a solicitor-client relationship and no duty of care is assumed or accepted. It does not constitute legal advice.