Ipso Facto Law Reform

As of 1 July 2018, if a customer, sub-contractor, service provider or other contractual counterparty (which, in this article, we will call “Counter Party”) enters into a form of external administration, you may be unable to exercise certain contractual rights such as step-in rights or termination rights. Businesses should consider what this will mean for their contracts and business processes.

The challenge

• Recent reforms to the Corporations Act 2001 (Cth) prevent contractual counterparties from exercising contractual rights, (including termination rights), as a result of the appointment of a voluntary administrator or a receiver to the Counter Party, or the Counter Party being subject to a scheme of arrangement.
• There are certain types of contracts that are excluded from the operation of the new provisions (see below).
• The ipso facto reforms take effect from 1 July 2018 and apply to contracts entered into on and from that date – there remains a small window of time to prepare and be ready for the changes before they take effect. Counterparties will still be able to terminate a contract for reasons unrelated to a Counter Party’s external administration – for example, the non-performance of an obligation such as a payment obligation or breach of covenant.
• Contracts should be checked without delay to maximise protection (to the extent possible) from these significant changes.
  

How we can help

For contractual counterparties, consideration should be given to:

• The ‘ipso facto’ provisions in your business’ contracts and any contractual or other mechanisms that might mitigate the risk to your organisation if any Counter Parties enter into external administration;
• If possible, varying existing contracts rather than entering into new contracts after 1 July 2018. However, it should be noted that a substantial variation to the terms and conditions of an existing contract may be deemed to be a new contract. While a contract variation could allow for the continued enforcement of ipso facto provisions contained in the existing contract, care will need to be taken to ensure that the varied contracts do not fall foul of the anti-avoidance provisions which prevent parties contracting out of the provisions;
  
• Strengthening default clauses and covenants in contracts bearing in mind the commerciality of such provisions;
  
• When entering into a new contract, ensuring that you have performed adequate due diligence on a Counter Party concerning its financial position and also ensuring that appropriate Personal Property Securities Act 2009 (Cth) registrations are in place; and
• Reviewing business policies and processes for dealing with Counter Parties to detect and deal with Counter Parties in financial distress before they enter into external administration.
  

Most commercial contracts will typically include the following express termination clause: Without limiting any other right A may have under this agreement or otherwise at law, A may terminate this agreement by notice in writing to B if an Insolvency Event occurs in respect of B.

An Insolvency Event is often defined to include circumstances where a company:
• is subject to any scheme of arrangement with its creditors;
• has a receiver or a receiver and manager appointed to any part of its property; or
• enters into voluntary administration.

This type of clause is commonly known as an ipso facto clause.

An ipso facto clause entitles a party to immediately terminate or exercise another contractual right under a contract on the occurrence of an Insolvency Event. The entitlement of a counterparty to rely on an ipso facto clause to terminate a contract may deprive a company of any prospect of economic recovery.

Exercising ipso facto rights, such as contract termination, is considered to be inconsistent with one of the key statutory objectives of the voluntary administration regime, namely: for the business, property and affairs of an insolvent company to be administered in a way that “maximises the chances of the company, or as much as possible of its business, continuing in existence.”

An example of this is below:

ABC Pty Ltd (ABC) manufactures widgets. It requires 3 components to make widgets, which are supplied by XYZ Pty Ltd (XYZ). The directors of ABC appointed an administrator 2 days ago. XYZ has elected to terminate its supply contract with ABC (and therefore cease supplying the necessary components for the widgets) relying on the ipso facto clause in its supply contract with ABC. As a result ABC cannot continue to manufacture widgets and instead of being in a position to continue trading, ABC must cease to trade.

The above example demonstrates the value destruction a company can suffer as a result of the exercise of a termination right in an ipso facto clause.

The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth) amended the Corporations Act 2001 (Cth) to impose a prohibition on the enforcement of rights against a company including, relevantly, contractual termination rights arising on the occurrence of an Insolvency Event.

Specifically, the prohibition prevents the enforcement of contractual rights because the company is in voluntary administration, receivership or subject to a scheme of arrangement. The legislation also captures broader Insolvency Event clauses by also preventing enforcement of those contractual rights because of “the company’s financial position” at the time that they are under voluntary administration, receivership or subject to a scheme of arrangement.

The reforms emulate to some extent the ‘ipso facto’ moratorium under Chapter 11 of the United States Bankruptcy Code.

Section 365(e)(1) of the Bankruptcy Code provides that a contract may not be terminated solely because of a clause in the contract ‘conditioned on the insolvency or financial condition of the debtor’.

As a consequence, the contractual counterparties will be ‘locked-in’ and required to continue to perform contractual obligations.

‘Locking-in’ suppliers and other contractual counterparties during voluntary administration, receivership or a scheme of arrangement is intended to assist in maintaining ‘business as usual’ conditions for the company’s trading during these insolvency processes. This should help prevent the unnecessary destruction of valuable and viable businesses, and thereby create a better opportunity for a successful restructure.

As detailed above, the amendments prevent the enforcement of contractual rights because of the corporation’s financial position where the corporation is under voluntary administration, receivership, or is subject to a scheme of arrangement.

Counterparties will still be able to terminate a contract for reasons unrelated to a Counter Party’s external administration or financial position - for example, for other non-performance of an obligation such as a payment obligation. However, where the counterparty has not taken steps in relation to such a default until after initiation of the external administration, it may be difficult to show that the reason for enforcement is for anything other than the external administration or financial condition of the company.

The Court has broad powers in relation to the operation of the stay on enforcing contractual termination rights.
On the application of, by way of example, the holder of the termination right, a Court:

• May declare that the stay on enforcing the contractual termination rights does not apply if such an order is in the interests of justice;
• Alternatively, may order that one or more specific rights under a contract will still be enforceable.

After the receivership ends or the company executes a deed of company arrangement, no enforcement of the ipso facto contractual right is permitted in respect of the earlier breach.

The amendments include anti-avoidance restrictions to prevent parties from contracting out of the operation of the ipso facto stay provisions in the Corporations Act.

The restrictions on the operation of ‘ipso facto’ clauses are subject to some exclusions. 

The  declaration made by the Minister on 20 June 2018, as well as the regulations registered by  the Government on 21 June 2018, list over 30 different categories of contracts  that are exempted from the prohibition on exercising rights under ipso facto clauses.

These include:

Government licences

• a licence, permit or approval issued by a government authority

Public benefit agreements

• agreements relating to national security, border protection and defence;
• the supply of goods and services to public hospitals and health services; and
• the supply of essential IT and communication technology products or services

Financial transactions

• agreements involving bonds, promissory notes and syndicated loans;
• agreements for the management of financial investments;
• agreements which are outsourcing arrangements under the Prudential Standards;
• agreements involving a special purpose vehicle and that provide for securitisation, a public-private partnership or a project finance arrangement; 

Other notable exceptions include the following contracts or contractual rights:

• rights of set off;
• rights of termination under a standstill or forbearance arrangement;
• sale of business;
• rights to appoint a controller of property in specified circumstances;
• contracts entered into on or after 1 July 2018, but before 1 July 2023, that relate to certain building projects with a value of at least $1 billion;

Also, institutions that have security over all of a company’s assets will be able to enforce their security during the first 13 business days of a voluntary administration. A company in external administration cannot force financial institutions or other providers of funding or credit to continue to provide additional credit or funding to it.

The reforms make significant changes, which should enhance the chances of companies achieving a successful restructuring through the external administration process.

Going forward, contractual counterparties will be required to adopt a different approach in managing Counter Party insolvency and should consider the terms of their contracts, policies and procedures for dealing with those situations.