From 1 July 2018, new restrictions will come into effect preventing parties from enforcing certain rights (including termination rights) triggered by insolvency events. The new laws seek to assist businesses undergoing financial distress to “maximise their chances of survival”, as termination of valuable contracts could potentially prevent such businesses from going through the necessary restructure in order to survive. However, interested parties have until 11 May 2018 to respond to the Exposure Draft of the relevant regulations with proposed exemptions to the new laws (Proposed Exemptions).

Reforms affecting termination on insolvency

It is common to include termination clauses in commercial contracts. In general, contractual rights of termination available to the parties entering into commercial contracts may include termination by default, termination for convenience and the “ipso facto” clauses.

“Ipso facto” clauses allow one party to terminate (or modify) the operation of a contract upon the occurrence of a specified event. Many commercial and financial agreements contain an “ipso facto” clause triggered by insolvency events. The main benefit of such clauses is that it gives a party the ability to exit a contract as soon as insolvency of the other party becomes a real risk.

In Australia, “ipso facto” clauses triggered by insolvency events have long been the subject of much debate and criticism. The ability for a counterparty to terminate key contracts as a result of the other party’s financial position (regardless of continued payment or performance by the other party of the contract as a whole) has proven to be a significant impediment to companies in financial difficulties trying to undergo genuine restructuring, or may prevent the sale of a business as a “going concern”. In April 2016, the Federal Government proposed a number of reforms to Australian insolvency laws and the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017 (Cth) (the Amendment Act) was passed in September 2017 to amend the Corporations Act 2001 (Cth) making “ipso facto” clauses unenforceable during formal insolvency processes.

Amendment will come into effect from 1 July 2018

The amendment regarding “ipso facto” clauses will come into effect from 1 July 2018 and will only apply to contracts entered into after 1 July 2018. Whilst the amended laws limit the use of such clauses, it does not make the actual contractual rights to terminate unlawful.

Under Part 2 of the Amendment Act, any expressed contractual rights are “stayed” and “temporarily unenforceable”, for a specified period of time, if any of the following types of external administration occurs:

Insolvency Event

Description

Duration of stay (i.e. the period when “ipso facto” clauses are unenforceable)

Start

End

Scheme of Arrangement

Part 5.1 of Corporations Act
When a company undertakes a compromise or arrangement with its members or creditors to avoid being wound up. When the company makes a public announcement or when a scheme application is made under s411 of Corporations Act. 3 months after the public announcement or when the application is withdrawn or dismissed unless the company is wound up in which case the stay will apply until the affairs of the company are fully wound up.

Receivership

Part 5.2 of Corporations Act
When a managing controller (e.g. receiver) is appointed to a company over the whole or substantially the whole of the company’s assets. When the managing controller is appointed. When the receiver or controller’s appointment ends.

Voluntary Administration

Part 5.3A of Corporations Act
When a company elects to appoint an administrator to investigate its financial affairs and assess its viability as a going concern. When the company enters administration. When administration ends unless the company is wound up in which case the stay will apply until the affairs of the company are fully wound up.

Under the amended legislation, an expressed contractual right is not limited to rights to terminate, it may be any right as long as it is triggered by a counter-party’s “financial position”. These include rights to call in bank guarantees, suspend works or modify the contract.

The length of stay is also subject to any court orders that may be in force. Businesses may apply to the court to extend the period of the stay or for an order that contractual rights can be enforced in the interest of justice.

Even after the stay comes to an end, contractual rights may still be unenforceable to the extent that:

  • the reasons for enforcing the rights relates to the company’s “financial position” before the end of the stay period, or
  • the company enters administration, appoints a receiver or enters into a scheme.

Exemptions to the amendment

As discussed, any rights linked to insolvency events in existing contracts entered prior to 1 July 2018 can still be enforced.

In addition, the restrictions do not apply to companies that are already in liquidation or engaged in insolvent trading. The stay generally does not extend to the appointment of liquidators (unless liquidation happens after a Scheme of Arrangement or Voluntary Administration). They also do not apply if the administrator, liquidator or person appointed to administer a scheme of arrangement has consented in writing to the enforcement of the right. This is why even though an “ipso facto” clause may be unenforceable, they still should be included in agreements entered into after 1 July 2018.

However, the Proposed Exemptions under the draft regulations and declarations released in April 2018 (and currently under consultation) exclude certain agreements and contractual rights from the stay. Some of these include:

PROPOSED EXEMPTIONS

Agreements or Contracts

under the Corporations Amendment (stay on Enforcing Certain Rights) Regulations 2018

Contractual Rights

under the Corporations Amendment (stay on Enforcing Certain Rights) Declaration 2018
  • Government licences or permits
  • Financial products and arrangements in the securitisation industry - includes derivatives, securities, margin lending facilities
  • Arrangements for sale of a business
  • Complex arrangements with sophisticated parties – includes arrangements with special purpose vehicles and keeping source codes in escrow
  • Arrangements relating to debt and priority of creditors – this includes subordination arrangements
  • Arrangements relating to financial markets, clearing and settlement facilities
  • Netting arrangements - mainly relevant to the construction industry
  • Agreements novating and assigning rights under contracts entered into before 1 July 2018 – the declaration has clarified that agreements entered into before 1 July 2018 can be novated, assigned or varied and the resulting arrangement are not subject to a stay under the new laws
  • Uplift clauses and indemnification clauses – clauses that allow lenders to enforce rights to charge a higher rate of interest upon an insolvency event and to rely on their indemnification rights to cover the lender’s increase risk and costs
  • Termination rights in standstill or forbearance arrangements – clauses which refrain lenders form exercising their enforcement rights upon an insolvency event
  • Right to change priority of payments
  • Rights of set-off and acceleration of such rights
  • Rights of assignment and novation – may effect the secondary debt trading market often used by businesses to restructure
  • Self-executing clauses – certain self-executing clauses are excluded to ensure no conflict with the Personal Property Securities Act 2009

Whilst some industries (such as the construction and banking and finance sectors) may welcome the Proposed Exemptions, other commentators are questioning whether the Proposed Exemptions undermine the Amendment Act’s main objective of assisting financial distressed businesses in Australia to restructure, especially since the Proposed Exemptions are broader than previously contemplated.

Will the amendment affect other contractual provisions?

The new laws do not affect other contractual rights including the right to terminate for reasons other than insolvency (e.g. termination by default, termination for convenience, automatic termination).

However, the legislation contains anti-avoidance provisions which can extend the stay to other reasons that are “in substance” contrary to the reforms and capture clauses which are seen as attempts to circumvent the new amendments to the legislation. The extent and scope of these anti-avoidance provisions are still uncertain and lawyers and businesses will be closely monitoring the application of these provisions, especially in light of the Proposed Exemptions.

Next Steps

Parties cannot contract out of the new provisions and wide regulatory powers have been given to the government to intervene and prevent parties from circumventing the new laws.

However, some steps may be taken to manage the effects of the new restrictions on contracts commencing on or after 1 July 2018. These include:

  • ensuring agreements entered into after 1 July 2018 include clear contractual rights to terminate based on non-performance and non-payment;
  • including specific performance requirements and lists of events of default to ensure that any rights for termination for breach are not be caught by the anti-avoidance provisions;
  • including a termination for convenience clause;
  • where applicable, including clauses in the agreement to protect the business during stay periods e.g. the party will not be required to make milestone payments if their rights to terminate have been suspended;
  • implementing better processes for selection of contractual parties to assess risk of insolvency of the other party such as conduct PPSR checks, reference checks, ASIC searches and inspection of the other party’s financial records prior to entering into a contract;
  • reinforcing unaffected rights in contracts such as obtaining parent company guarantees and rights to inspect financial statements at any time;
  • considering whether it is an option to extend existing agreements (which contains “ipso facto” clauses) entered into before 1 July 2018 in order to retain the benefit of such termination clauses for a longer period. Even if an agreement does not contain options to extend, parties may be able to use a deed of variation to vary the terms or insert options to extend the contract before the new law comes into effect. The Proposed Exemptions have clarified that all arrangements that are a novation or assignment of rights under an agreement entered into before 1 July 2018 will not be subject to the Amendment Act; and
  • consider responding to the Proposed Exemptions on the Treasury’s website by 11 May 2018.