On 29 April 2016, the Australian Government Treasury released a proposal paper that, among other things, proposed reforms to introduce an ipso facto moratorium (Proposal). This reform was foreshadowed in as part of the Australian Government’s National Innovation and Science Agenda.
We have been monitoring the reform process as it continues through the consultation phase – see our previous alert here. Ipso facto reform is a key aspect of the reforms that the Government committed to in December 2015. It has particularly broad scope.
Converting Latin to English – what are we talking about?
Ipso facto clauses are provisions that terminate a contract upon an insolvency event of a party (such as the appointment of an administrator or receiver).
For example, a contract may provide that one party may terminate that contract if an “Insolvency Event” occurs in respect of the other party. This is often used to mitigate counterparty risk, but may hinder attempts to rescue a distressed company.
The Australian Government has proposed that “any term of a contract or agreement which terminates or amends any contract or agreement (or any term of any contract or agreement), by reason only that an ‘insolvency event’ has occurred would be void”.
The reference to “amends” indicates that the moratorium may extend beyond clauses providing for termination, to provisions that seek to alter the rights between contracting parties upon the insolvency of one of them.
The Proposal states that the ipso facto prohibition have an ‘anti avoidance’ mechanism. This would prevent amendments to contracts which are designed to “work around” the prohibition, giving it a very broad application to contracts governed by Australian law.
How does this affect financial markets?
Throughout the financial markets, it is common for the rights of a person to be altered upon the insolvency of their counterparty.
The most obvious example is in the context of swaps, where a counterparty is entitled to close out their position to manage counterparty risk.
Don’t fear – the Proposal contemplates a carve-out for “prescribed financial contracts”, which the Government’s statement says will include swaps. The Proposal also indicates that close-out netting arrangements will be excluded through designation as “prescribed financial contracts”.
More generally, the Proposal expressly acknowledges the importance of preserving counterparty termination rights in international derivatives markets. This gives some comfort that the ‘anti avoidance’ aspect of the reforms will be crafted around the specific requirements of those markets.
The Proposal has invited submissions on what else the “prescribed financial contract” carve-out should cover. Two that immediately come to mind are flawed assets and flip clauses (if these would indeed constitute an “amendment” of a contract, rather than an essential condition to the ability to exercise a right).
Flawed assets are rights that are “flawed” in that the rights are conditional upon some event or circumstance occurring or continuing. Where a circumstance (such as solvency) is a fundamental condition of a right, the application of an ipso facto moratorium to such provisions would fundamentally alter commercial bargains.
So called “flip clauses” subordinate payments to a person upon their insolvency. This is commonly seen in structured transactions such as securitisations, where a party’s (often a swap counterparty) right to payment is subordinated to other creditors following their insolvency or other default.
It is encouraging that the Government is alive to the sensitivity of financial markets to theipso facto reforms. That said, the application of the reforms to the financial markets and the carve-outs required for efficient financial markets will need to be carefully considered through the consultation process.
The breadth of the ipso facto preclusion, particularly the effect of the anti-avoidance mechanism currently being considered, will require careful analysis and review as the consultation process moves from a conceptual level to consider specific legislation.
We will continue to analyse the full proposal paper, which is available here.