Parties to a contract could be exposed to higher levels of risk than intended following the introduction of the new ‘ipso facto’ regime on 1 July 2018. From the new financial year, a party to a contract will no longer have the right to automatically terminate the contract if the other party suffers an insolvency event, such as entering into voluntary administration. These changes could have far reaching implications when drafting and negotiating contracts.
What you need to know:
Contracts have typically included an ‘ipso facto’ clause that allows a party to the contract to terminate (or to alter the terms of) the contract on the occurrence of certain events relating to the creditworthiness of the counterparty (such as the insolvency of that counterparty), irrespective of the counterparty’s continued performance of obligations under the contract.
The new ipso facto provisions restrict the right of a party to rely on an ipso facto clause to terminate or suspend the contract merely because the other party suffers an insolvency event, for example, entering voluntary administration.
As the legislation only imposes a temporary stay on enforcing the contractual provisions, the contractual right to terminate is not void, voidable, or invalid. This means ipso facto provisions in contracts do not have to be removed from existing contracts. Contracting parties need to be aware, however, that such provisions will not be able to be enforced as originally intended.
The reforms aim to shift focus from insolvency to restructuring by keeping contractual relationships active, so a company facing insolvency can continue to trade through to recovery, rather than face liquidation or winding up.
New ipso facto reforms
The new ipso facto reforms to the Corporations Act 2001 are a response to increasing rates of insolvency in the construction, property, and projects sectors. The reforms aim to provide a greater chance of trading out of insolvency and prevent businesses being wound up.
The contracts that will be impacted by the new reforms include contracts entered into from 1 July 2018 that include provisions permitting the immediate termination of the contract where the other party enters into voluntary administration or some other form of voluntary administration. Importantly, factual insolvency (where a party cannot pay its debts as and when they fall due), will not trigger the stay on an ipso facto provision in a contract. The relevant party must enter into voluntary administration, receivership or a scheme of arrangement. The stay will generally end when the period of voluntary administration ends or the company is wound up.
Anti-avoidance provisions have also been introduced that require a party to obtain leave of the court to exercise certain rights under a contract to ensure any action taken by a contracting party is not inconsistent with the stay on the ipso facto provisions. For example, if a contracting party wishes to exercise a right to call on a guarantee, take possession of a security asset, make a set-off claim, or engage subcontractors directly, the party will need to apply for the leave of the court as exercising any of the above rights could in substance undermine the effect of the new ipso facto regime.
Importantly, the legislation does not apply to an ‘insolvency event’ termination clause in a contract or agreement for the sale of all or part of a business, including a sale of securities or financial products. While a purchaser acquiring a business would generally conduct thorough due diligence, the financial position of the business and the seller is usually difficult to determine and as such, the warranties of the seller as to its solvency are relied on by the purchaser.
Further, if the ipso facto reforms were to apply to the sale of a business, it is likely that the price would be adjusted down to compensate for the increased risk of the purchaser, making it even more difficult for a financially distressed seller to achieve a market value sale price for the business.
Accordingly, this exclusion ensures the transaction risk is determined by negotiations between the parties to the contract, and the purchaser can continue to rely on the solvency warranties of the seller, including terminating the agreement where the warranties are not satisfied.
Assignment of rights or variation
A further key exclusion applies to contracts or agreements entered into or renewed on or after 1 July 2018 as a result of:
- the novation or assignment of one or more rights under a contract or agreement entered into before 1 July 2018; or
- the variation of a contract or agreement entered into before 1 July 2018.
Therefore, it is likely that purchasers under contracts or agreements entered into before 1 July 2018 will seek to vary the terms of a contract rather than negotiate a new contract. This may give rise to disputes regarding when the variation to a contract is such that it constitutes a new contract.
The provisions will only apply to contracts entered into from 1 July 2018, and will not apply retrospectively. Importantly, rights which do not pertain to termination for financial reasons are not stayed, for example, a principal may still terminate a contractor in cases of non-performance or non-payment.