For many suppliers, creditors and landlords, the threat of their counterparty’s insolvency is mitigated by a right to terminate or vary their contracts if there is an “insolvency event”. From July 1 2018 changes to the Corporation Act 2001 (Cth) may, however, limit those rights. The amendments which make ipso facto clauses in contracts unenforceable during certain insolvency-related processes, comes as a package of two major reforms, the other part of the packing being the ‘safe harbour’ provisions for company directors in periods of financial distress which took effect in September 2017.

These changes arose from an acknowledgment by the Australian Government that our insolvency laws disproportionately stigmatise and penalise company failure, at the expense of entrepreneurship and innovation.[1] It is hoped that these reforms will reduce instances of the premature resort to formal insolvency processes, resulting in better prospects of turnaround for companies and the preservation of value for creditors and shareholders. In turn, the Government hopes to see a cultural shift away from the stigmatisation of failure and towards reasonable risk-taking for the ultimate benefit of the companies and people involved.

So what are the changes?

Ipso facto clauses

Ipso facto clauses create a contractual right to modify or terminate a contract upon the occurrence of a “specific event”. Relevant here is the right to terminate a contract if the company enters administration, is wound up in insolvency or a manager controller is appointed. Ipso facto clauses have been long viewed as an important self-protection mechanism for suppliers, credit providers and landlords, but they do have the effect of inhibiting the successful turnaround of struggling companies.

By cutting off vital contractual relationships, businesses in financial distress are deprived of their capacity to continue trading while they restructure, destroying its enterprise value and potentially deterring potential investors who may have otherwise bought out the business and attempted to turn it around. This may defeat the very purpose of entering into administration or schemes of compromise or arrangement, and may prejudice creditors should the company be wound up.

From 1 July 2018 new provisions in the Corporations Act[2] prevent a party from enforcing an ipso facto clause during a “stay period”. While a party can apply to have the stay lifted “in the interests of justice” [3] or to seek an order that the ipso facto clause is enforceable[4], the stay period will usually end only if the company exits administration or if the compromise or arrangement period ends, otherwise it will continue until the liquidation has been completed.

When are ipso facto clauses enforceable?

Ipso facto clauses in contracts that were entered into prior to 30 June 2018 are still enforceable. Further, ipso facto clauses that:

  1. modify rates of interest in finance arrangements (loans, guarantees, indemnities, security);
  2. allow a party to enforce an indemnity for enforcement expenses;
  3. can terminate a forbearance arrangement;
  4. change the priority or order in which amounts are to be paid;
  5. allow a set-off or combination of accounts;
  6. allow an assignment, transfer or novation of rights; or
  7. allow circulating security interests (floating charges) to become non-circulating security interests (fixed charges)

are also still enforceable[5].

Despite the amendments to the Corporations Act, counterparties to a contract may still terminate or amend the contract on other grounds, such as breach. As a trade-off, the company that benefits from the “stay” of the counterparty’s rights to terminate will not be able to exercise their own rights to seek further advances of money or credit under the contract, therefore minimising risk of ongoing exposure for the counterparties.

Practical challenges

The aim of these changes is to provide a struggling company some breathing space, allowing the company to continue operating while directors attempt to restructure the business. Not only does this improving its bargaining position when attempting to negotiate restructure options with creditors, it may preserve the value of the business for the benefit of the company, its employees and its creditors.

That said, the amendments create further motivation on contracting parties to ensure that they are closely managing contract performance—addressing underperformance early and often to minimise exposure to the other’s insolvency, and reserving their rights to terminate for breach if the default is not rectified.