What do the ipso facto reforms mean for the construction sector?

On 1 July this year, new provisions of the Corporations Act came into effect which place critical limitations on the exercise of contractual rights where the counter-party enters into a formal restructuring or insolvency process (receivership, voluntary administration or a creditors scheme of arrangement).

Businesses operating in the construction industry face a higher risk than any other industry of either entering into insolvency themselves, or becoming a victim of insolvency further up or down the contracting chain.

The construction industry has accounted for 8-10% of GDP over the past decade, but has also accounted for 20-25% of all insolvencies in Australia. There are, on average, more than 1700 insolvencies in the construction industry every year. These 1700 insolvencies affect thousands more creditors.

The Australian newspaper reports yesterday that the Australian Performance of Construction Index fell by 3.4 points. According to the same news report, in June 2018 “the residential sub-sectors detracted from the industry’s momentum with apartment building continuing its orderly retreat from boom conditions.”

In this update, we provide insights about how construction businesses' contractual rights will be affected by the recent law reforms and make suggestions for mitigating the risk of counter party financial distress and insolvency.

What is an ‘ipso facto’ clause?

“Ipso facto” means “by the fact itself”. Ipso facto clauses are contractual clauses that allow one party to exercise a right by reason of insolvency of the other party, regardless of whether the other party has continued to perform its obligations under the contract.

A typical clause in a contract may provide:

“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”.

Other forms of clause list events indicating insolvency and provide that, if one of these events occurs, the other party may terminate the contract (eg see clause 39.11 of AS 4902).

The entitlement of a counterparty to rely on an ipso facto clause to terminate a contract may destroy the value of a company and deprive the 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.

The reforms

The ipso facto reforms are part of the National Innovation and Science Agenda and are aimed at bringing restructuring and insolvency laws into line with the global approach, to promote a culture of entrepreneurship and innovation and to help reduce the stigma associated with business failure.

The reforms are set out in the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth), which amends the Corporations Act 2001 (Cth).

The reforms come into force on 1 July 2018.

The reforms stay the enforcement of contractual rights:

• for the reason that the other party is under voluntary administration, receivership (of the whole or substantially the whole of the corporation’s property), or is subject to a scheme of arrangement; or
• because of the other party’s financial position, where the other party is under voluntary administration, receivership, or is subject to a scheme of arrangement.

The aim is to allow breathing space for a company to continue to trade during a formal restructure.

Parties cannot contract out of the reforms. The reforms also include anti-avoidance mechanisms. In particular, rights cannot be enforced for a reason that, in substance, is contrary to the stay provisions.

The stay on enforcing rights does not apply to all types of insolvency event, but only to the above events. For example, the stay does not apply to liquidations.

Note that, in relation to receivership, the stay only applies where a receiver is appointed in relation to “the whole or substantially the whole of the corporation’s property.”

The stayed right is unenforceable against the other party indefinitely after the end of the stay period, if a reason for seeking to enforce the right is the company’s financial position before the end of the stay period, or the company having been under administration, receivership, or scheme of arrangement (or certain other reasons).

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”.

Rights that are not affected by the stay provisions

Parties will still be able to exercise rights (such as termination rights, suspension rights and rights to call on security) in the following circumstances:

• where the contract was entered into before the reforms commenced on 1 July 2018;
• for reasons unrelated to the other party’s external administration or financial position - for example, termination for default (but the party would need to prove that the reason for termination was the other party’s default and not their insolvency);
• where the particular type of insolvency event is not one of the events subject to the reforms (eg liquidation);
• where the contract is one of the excluded kinds of contracts described in the Regulations (see clause 3 below);
• where the right is one of the excluded kinds of rights described in the Declaration (see clause 3 below);
• where the administrator/ liquidator/ receiver has consented in writing to the enforcement of the right; and
• pursuant to a Court order, where the Court is satisfied that this is appropriate in the interests of justice.

The situation in relation to termination for convenience provisions is unclear. In theory, if the right is exercised for convenience and not because of the other party’s financial position or the restructuring process, the stay would not apply. But in practice it may be very difficult to establish that the reason for the termination was not connected with the other party’s insolvency.

A purported termination which is contrary to the ipso facto reforms could amount to repudiatory conduct, and place a party at risk of legal action for wrongful termination.

The Corporations Amendment (Stay on Enforcing Certain Rights) Regulations 2018 (Cth) (Regulations) and the Corporations (Stay on Enforcing Certain Rights) Declaration 2018 (Cth) (Declaration) set out types of contracts and contractual rights that will not be subject to the stay. The contracts and rights which are potentially relevant to the construction industry are discussed below.

Regulations: prescribed types of contracts which are not subject to the stay

Contracts which relate to the following matters will not be subject to the legislative stay include the following:

• National security, border protection, defence capability
• Public hospitals and public health services
• Special purpose vehicles for PPPs
• Novation/ variation of pre-1 July contracts
• A contract, agreement or arrangement entered into or renewed on or after 1 July 2018, but before 1 July 2023, as a result of:
  - novation of, or the assignment of one or more rights under a contract, agreement or arrangement entered into before 1 July 2018; or
  - variation of a contract, agreement or arrangement entered into before 1 July 2018, is not subject to a stay.

Building projects with total payments of at least $1 billion

Due to the complex nature of large scale construction projects, the arrangements for or that support the completion of the project have been excluded for a period of 5 years. This transitional period recognises the nature of such projects, and provides certainty and stability about the operation of the ipso facto stay to these construction projects, while allowing parties time to consider how to structure affected arrangements in the future.

The provision intends to capture the work done on, or goods or services provided to, multiple work sites which, collectively, form part of a particular project. This recognises that a construction project, such as for a residential suburb or a railway or road, might take place at more than one site.

The provision draws on the meaning of “building work” in section 6 of the Building and Construction Industry (Improving Productivity) Act 2016 (BCI Act). This is a broad definition, with exclusions for extraction of oil, gas and minerals and for single dwelling-house projects (but not projects for multi-dwelling developments with at least 5 single dwelling-houses).

The provision also includes certain items of work within the meaning of “construction work” in section 5 of the Building and Construction Industry Security of Payment Act 1997 (NSW) (the NSW Security of Payment Act). According to the Explanatory Statement, the reason for the inclusion of reference to the NSW Security of Payment Act in addition to the BCI Act was to extend the scope of the exclusion to the matters covered in section 5(1)(d) and (f) in the NSW Security of Payment Act, being:

• the external or internal cleaning of buildings, structures and works, so far as it is carried out in the course of their construction, alternation, repair, restoration, maintenance or extension; and
• the painting or decorating of the internal or external surfaces of any building, structure or works;

as long as they are not subject to the exclusions in section 5(2) – for example, mining for oil, gas or minerals.

The provision also extends to “related goods and services” as defined in section 6 of the NSW Security of Payment Act (for example, materials and components to form parts of buildings, plant and materials for use in connection with carrying out the work, labour, design and other services – refer to section 6 for the full list).

While the provision draws on definitions in the NSW Security of Payment Act, those definitions are intended to extend to work, goods and services provided anywhere in Australia.

The exclusion only applies where the “total payments under all contracts, agreements or arrangements for the project for work, goods or services of those kinds is at least $1 billion”. The threshold of $1 billion is intended to be tested against the value of all payments made under all arrangements for the project for work, goods or services of those kinds in subparagraphs (zo)(i) to (iii). This could require the head contractor or procurer to work out the value of the payments to be made under all contracts and subcontracts for the particular project, and determine whether they come to at least $1 billion.

This aspect of the exclusion appears likely to create uncertainty and difficulties in application – for example it may be difficult for parties lower down the contract chain (eg subcontractors) to ascertain whether the overall project exceeds the $1 billion threshold.

Subclause (zp) intends to capture all subcontracts that have been entered into to enable the satisfactory completion of the primary project, and that also provide work, goods or services, so that these arrangements are excluded from the operation of the ipso facto stay.

Declarations: kinds of rights to which the stay does not apply

In addition to the exempted kinds of contracts described above, the Declaration also exempts certain kinds of rights under all contracts. The exempted rights that are likely to be relevant to those in the construction industry are:

• Rights to indemnity
• Rights of set off
• Rights to assign, transfer or novate rights or obligations
• Rights to step in.

In relation to rights to step in, the Declaration describes the protected right as a right:

• to perform obligations;
• to engage another person to perform obligations;
• to enforce rights; or
• to engage another person to enforce rights;

of the insolvent party under the contract, agreement or arrangement.

The exclusion was amended from the exposure draft in the final version to confirm that a party can engage another person to perform the obligations or enforce the rights.

The Explanatory Statement states that these arrangements are designed to keep the contract on foot where it might otherwise have been terminated – they should not be disturbed as they support the overarching policy objective of allowing a business to continue and/ or maintain value for the insolvent or restructuring entity.

Contract terms

Despite the reforms, where appropriate, we recommend including “termination for insolvency” provisions in contracts because they may still be able to be exercised if the administrator, controller, or scheme administrator consents or the Court allows it.  There may also be other circumstances where the stay mechanism does not apply (for example, see clause 2.3 above).

Note that is not possible to contract out of the effects of the ipso facto reforms, and there are strict anti-avoidance provisions to prevent parties from trying to circumvent the reforms.

There are some contractual provisions that parties can include to help minimise the impact of the ipso facto reforms.

Ipso facto awareness

Even though we recommend continuing to include ipso facto provisions in contracts, construction industry participants need to be aware that rights which a party appears to have under the contract, such as termination rights, could potentially be the subject of a stay as a result of the ipso facto reforms. A stay is more likely to apply when the insolvency of the other party is in doubt.

If you purport to terminate a contract in contravention of an ipso facto stay, this could amount to repudiatory conduct, and could place you at risk of a claim for wrongful termination.

The ipso facto reforms are not intended to prevent a party from terminating a contract as a result of default by the counterparty, but if the counterparty is insolvent then the ipso facto reforms make termination for default more complicated. It would be important to ensure that there is sufficient evidence to prove that the counterparty is in default and that this is the reason for the party’s termination of the contract (and not the external administration or financial condition of the company).

If you have concerns about the financial position of a counterparty to a construction contract, you should seek legal advice on your particular situation before purporting to exercise a right such as a right of termination.

Business processes and contract administration

It will also be prudent for construction industry participants such as building contractors to build into their internal processes and policies due diligence on the financial standing of tenderers and counterparties, for example:

• including financial tests and requirements to provide financial information as part of the tender process;
• monitoring of performance in order that the exercise of performance-related rights can be considered as soon as these rights arise; and
• even if rights to require financial information are not strengthened, greater awareness of the indicators of financial distress (such as failure to pay subcontractors or simply market rumour) and readiness to act on this information.