New insolvency reforms are on the way: How will they affect you?

As part of the implementation of the Turnbull government’s National Innovation and Science Agenda, a suite of insolvency reform laws have been introduced, aimed at encouraging entrepreneurship rather than punishing corporate failure. The objective of these new laws is to provide viable but underperforming companies an opportunity to implement a turnaround strategy or sale of the business.

The Treasury Laws Amendment (2017 Enterprise Incentives No 2) Bill 2017 (the Amendment) received Royal Assent on 18 September 2017. The centrepieces of this legislation are amendments to the Corporations Act 2001 (Cth) (Act) to introduce:

1. ‘Safe harbour’ provisions, which provide an exception to the prohibition on insolvent trading by company directors; and
   
   
2. A stay on the enforcement of so called ‘ipso facto’ clauses in a contract.

The safe harbour provisions came into effect on 18 September 2017 but the ipso facto provisions are due to come into effect on 1 July 2018.

It is the second of these, the stay on ipso facto clauses, that is discussed in more detail below.

What is an ‘ipso facto’ clause? 

The term ‘ipso facto’ is generally used to describe a clause in a contract which allows one party to terminate a contract on the basis of a proscribed insolvency event occurring, such as the company entering into voluntary administration or receivership.

Numerous types of contracts contain clauses of this nature, but construction and supply contracts are among the most common examples.

The Amendment imposes a stay on the exercise of a right to terminate a contract merely as a consequence of:

• the appointment of a voluntary administrator;
• the appointment of a receiver or controller; or
• the proposal of a scheme of arrangement.

Other termination rights which may exist are not disrupted and parties will continue to be able to terminate contracts on other grounds, such as default in payment or non-performance. The insolvent counterparty must be able to continue to perform the contract regardless of the insolvency event.

The period covered by the stay will vary depending on the type of insolvency process, but will generally commence on the date the company comes under external administration and end on the date when the administration or receivership ends, in accordance with a court order or when the company is wound up.

What does the ipso facto reform mean for those contracting with parties under external administration?

From 1 July 2018, counterparties with contracts entered into after 1 July 2018 will not be able to rely on a right to terminate triggered by, or arising as a result of, the insolvency events referred to above.

This stay on enforcement will not apply to:

• contracts entered into before 1 July 2018; or
• any variations or amendments which occur after 1 July 2018 to contracts entered into prior to 1 July 2018.

The existence of dual regimes to deal with pre and post 1 July 2018 contracts will bring added complexity for both insolvency practitioners appointed to the insolvent company and the counterparties to contracts. It may also, for a period, encourage a rush of contract extensions rather than renegotiations in an attempt by potentially affected counterparties to maintain the status quo.

How this will impact on ‘step in’ rights (which often flow from the termination of a contract, particularly in the construction industry) and calling on bank guarantees is yet to play out.

Other elements of the legislation to keep in mind 

1. The stay will not apply to a secured creditor’s rights to take enforcement action during the ‘decision period’ in a voluntary administration.
   
   
2. When prevented from exercising ipso facto termination rights, counterparties will not be required to advance new money or credit under an existing contract.
   
   
3. Parties cannot contract out of the stay.
   
   
4. A holder of ipso facto rights can make an application to the court that the stay be lifted where it is in the interests of justice to do so.
   
   
5. The ipso facto reform does not apply to liquidation. This is due to the fact that liquidation is typically terminal for a company and accordingly, there is no utility in locking in contractual obligations.

Looking ahead

Companies with their key assets in contracts are likely to benefit greatly from the ipso facto reform. This is because the value of their business will be largely preserved during a restructuring or turnaround provided they continue to perform the contracts.

It remains to be seen, however, whether the reform will also benefit the counterparties to these contracts. by enabling a distressed company to address underlying performance issues through a restructuring and return to the economy as viable and strong companies with which to do business.

Given that the reform only applies to contracts entered into after 1 July 2018, we are unlikely to see how it will work in practice for some time. You should seek our advice if you have any contracts due for renewal on or after 1 July 2018.

In the meantime, it is worth noting that as a matter of practicality, companies that are in distress largely fall into two buckets – the first being companies which are fundamentally viable and need some assistance to turnaround, and the second being companies which are not viable and ultimately should cease trading.

It is likely that counterparties to contracts with companies in the first bucket will see the benefit of working with the company during a restructuring (which happens now irrespective of the existence of ipso facto termination rights). In the case of the second bucket, however, it is highly likely that these companies will not be in a position to perform the contract in any event, giving rise to a right to terminate the contract.