The new ipso facto insolvency reforms are set to impact the construction and property industries.
From 1 July 2018 the ipso facto insolvency reforms apply to new contracts, agreements and other arrangements.
The reforms, which are part of government's safe harbour and insolvency law reforms, prevent a party from exercising a right under a contract, agreement or arrangement which arises solely on the basis of one of the following types of formal restructuring processes:
- the appointment of a voluntary administrator;
- the appointment of a receiver or managing controller over all or substantially all of a company's property;
- a company undertaking a scheme of arrangement for the purposes of avoiding being wound up in insolvency; or
- an event or circumstance relating to the affected party's financial position if an appointment or scheme of arrangement referred to in an earlier paragraph has been made or undertaken.
Rights which may be affected include the right to terminate, suspend performance, step-in, novate and, in some cases, call on security. A party retains its entitlement to enforce a contractual right for any other reason i.e. where the right does not arise solely as a result of one of the events described above. For example, if the counterparty is in breach of its payment or performance obligations, the other party will be able to exercise its rights under the contract in respect of those breaches.
Key points to consider
The stay only applies to contracts made after 1 July 2018. This means that any insolvency-related terminations in existing contracts, including existing contracts which are amended after 1 July, are still enforceable.
If a party obtains the written consent of the administrator, receiver or scheme administrator, or an order of the court, they will be permitted to enforce their right under a clause that circumvents the stay on enforcement of an ipso facto right. Case law from overseas suggests these court orders will not be made lightly.
Contract managers and contract administration teams need to be educated on the impacts of the ipso facto amendments on their contracts. Contract managers who do not properly understand the reforms may, for example, put a company at risk of wrongfully repudiating the contract.
The ipso facto reforms potentially amplify the risks associated with the insolvency of a counterparty, and in that context, they provide a useful prompt for parties to review the processes and contractual remedies in place to mitigate the insolvency risks.
Exemptions to the stay relevant to the construction and property industry
There is a long list of exemptions to the statutory stay in the Corporations Amendment (Stay on Enforcing Certain Rights) Regulations 2018 (Cth) (Regulations). The Regulations provide for the types of contracts, agreements or arrangements that the stay does not apply to. For the construction and property industry, the key exemptions to arrangements to consider are those:
1. Involving a special purpose vehicle (SPV) that provides for a public-private partnership (PPP) or project finance
2. For defined building work, where the total payments are a minimum of $1 billion
3. Involving Australia's national security, border protection or defence capability
4. For the supply of essential or critical goods or services, or for the carrying out of essential or critical works, to or for government, or to or for the public on behalf of government.
5. For the supply of goods or services to, or on behalf of, a public hospital or public health service
6. Relating to Government licences, permits or approvals
The Corporations (Stay on Enforcing Certain Rights) Declaration 2018 (Cth) (Declaration) sets out the types of rights that the statutory stay does not apply to. Key exemptions under the Declaration include step-in rights (i.e. the right to perform obligations of the counterparty under the contract) and the right to assign or otherwise transfer (one's own) rights or obligations under the contract.
Some impacts for the construction industry
From a builder's perspective, it is important to note that the statutory stay applies to contractual rights. The ispo facto reforms will not affect statutory rights e.g. rights accruing under the security of payment legislation or through statutory liens.
For principals, certain (temporary) step-in rights are also protected from the statutory stay. However, the permanent replacement of an affected person e.g. by procuring a novation of their rights and obligations under a contract, will not be protected and will be subject to the stay.
The language of the exceptions is open to interpretation and, as they are new, there is no judicial direction to rely on. Accordingly, the detailed wording of each exemption needs careful consideration to ensure that clients take advantage of the exemption.
For example, while a ‘PPP’ and ‘project finance’ exemption may exist, not all contracts or counterparties within the complex suite of contractual arrangements comprising those transactions will necessarily have the benefit of those exemptions.
Depending on the circumstances, a builder, subcontractor or a principal may be a key creditor in the insolvency of a person involved in a construction project. The broad protections given to financiers and financing arrangements and the Project proponent (in the case of a PPP) means that some creditors to a project (eg, suppliers and builders being paid in arrears) may be disadvantaged, in relative terms, to other creditors (eg, project financiers, lenders under syndicated loans). That is, some creditors to a project will be unfettered in the exercise of their rights, while other creditors and counterparties will be unable to exercise their insolvency-event triggered rights (at least until other payment or performance defaults arise).
Some impacts for the property industry
There will be impacts for the property industry, for example, leases, which are not covered by the exemption. However, the situation largely remains unchanged. Already landlords usually take into consideration a number other overriding rights or restrictions not specifically addressed in a lease before terminating it. Going forward, a landlord will not be able to terminate for an insolvency event alone. While specific changes to the termination clauses in leases are not mandatory, we recommend that termination rights for insolvency be made subject to Chapter 5 of the Corporations Act 2001 (Cth) which will draw to the parties’ attention that the new laws have been taken into account and must be complied with.
How to mitigate your risk
- Review contracts and consider whether amendments are required to ensure that any rights currently activated by an insolvency event or the financial position of the counterparty remain available in a default situation. Amendments may include:
- bolstering performance based triggers (e.g. to include specific performance based defaults based on how an insolvency event might manifest itself in terms of time, quality and performance and payments) - noting of course that these might be difficult to identify in advance and also that it may only be viable to explore this option for high value / high risk contracts;
- shortening the timeframes for remedying defaults;
- including additional drafting to make use of the statutory exemptions e.g. including warranties as to a party's status as an SPV;
- including a contractual requirement that, if an external controller is appointed, the non-defaulting party may terminate the contract if the external controller does not confirm in writing, within a prescribed period of time, that the insolvent party will continue to perform its obligations under the contract. This amendment is not a 'fail-safe' termination option, but it may at least trigger dialogue between the parties;
- adding drafting to the provision dealing with the right to terminate for an 'Insolvency Event' (or similar) which makes it expressly subject to the statutory stay provisions in the Corporations Act 2001 (Cth), so that contract administrators are at least prompted to consider the effect of any potential stay before exercising the termination right; and
- reviewing security arrangements to determine whether additional performance security is required.
- Consider whether existing processes in respect of pre-qualification and financial due diligence of counterparties is adequate. Financial due diligence may extend to key subcontractors and the counterparty's broader group of companies.
- Educate and train contract managers and project teams on the ipso facto reforms to ensure the risks are properly managed e.g. so that contracts are not wrongfully terminated (repudiated).
- Consider the implication of varying, restating, novating, or replacing a contract after 1 July 2018 in light of the "application of amendments" provision of the Act.
- Where a contract has a connection with a foreign jurisdiction, consider the implications of the reform when selecting the governing law of the contract.
- Consider the need to qualify advices to stakeholders concerning the operation and enforceability of contractual terms on insolvency in light of the ipso facto reforms.