From 1 July 2018, amendments to the Corporations Act restrict the ability of government agencies to exercise contractual rights under ipso facto clauses where a contract party suffers a specified insolvency event. Put simply, this will limit an agency’s rights to terminate a contract because a supplier collapses, and will require different risk management strategies.
The new laws only apply to contracts entered into on or after 1 July 2018. In addition, there are a number of exemptions from the new laws, some of which specifically recognise the special nature of many government contracting arrangements.
What is ipso facto and why the change?
An “ipso facto” clause allows a party to exercise a right (e.g. terminate a contract) by virtue of the contract party’s insolvency, irrespective of whether it has defaulted in the performance of the substantive obligations under the contract.
The changes are part of the Commonwealth Government’s National Innovation and Science Agenda. The aim is to provide financially distressed companies with breathing space, to increase the chance of a restructure or sale of ongoing business operations. Ipso facto clauses allow key customer and supplier contracts to be terminated due to the insolvency event, thus lessening the chance of salvaging the business. In the words of an insolvency practitioner at a recent presentation we attended “ipso facto changes the conversation”.
What events are caught?
A party will be stayed from exercising contractual rights against a company due to the occurrence of a specified insolvency event, being:
- appointment of a receiver/receiver and manager over all or a substantial portion of a company’s property
- appointment of a voluntary administrator
- the company commencing a creditors’ scheme of arrangement.
In addition to the specified insolvency events, the amendments include anti-avoidance provisions to prevent parties from exercising rights which do not directly relate to an insolvency event, but which are being exercised because of it. The anti-avoidance sections capture contractual rights triggered by clauses such as material adverse effect/material adverse change, financial covenant breach and even termination for convenience rights.
The enforcement of contractual rights are stayed for the length of the relevant insolvency event. After conclusion of the stay period, the contractual right to terminate (or exercise other rights) on the basis of the original insolvency event remains unenforceable.
The ipso facto provisions are not intended to prevent a party from exercising rights for substantive breach (e.g. payment default or failure to perform obligations under the contract).
What contracts/rights are excluded?
The new laws provide for a range of exclusions of contracts and contractual rights from the stay.
Firstly, the ipso facto provisions apply only to rights arising under agreements which are entered into from 1 July 2018. In addition, amendments, variation and novations of pre-1 July 2018 contracts do not bring these contract within the ipso facto restrictions (but only up to 30 June 2023).
Classes of contracts and rights excluded from the ipso facto provisions which are relevant for government agencies are:
- Government licences: a licence, permit or approval issued by a government authority can be cancelled. This recognises the statutory nature of licences and approvals, even where licence terms are contained in a contract.
- Arrangements for the supply of essential or critical goods or services to, or the carrying out of essential or critical works for, Government: What constitutes ‘essential or critical’ goods, services or works has not been defined. However, the Explanatory Statement to the Second Amending Regulations provides as examples public transport services, public security or safety services, and works affecting essential public infrastructure and services essential to the provision of essential services, including signalling services for public transport, and maintenance services and cleaning services for vehicles used in providing public transport services.
- Arrangements for the supply of goods or services to, by, or on behalf of a public hospital or a public health service: This intends to capture arrangements for the supply of goods and services, such as medical or hospital equipment, fixtures and fittings, infrastructure and building works and other vital services for the operation of public hospitals or public health services. It is also intended to capture arrangements for the supply of goods or services provide on behalf of the public hospital/public health service, such as patient transport or arrangements for external care of patients.
- Contracts with Special Purpose Vehicles: Arrangements that involve contracting with a special purpose vehicle (i.e., an entity that is established for the sole purpose of the particular activity) and which provide for securitisation, a public-private partnership or certain project finance arrangements. The exclusion recognises that such arrangements are usually heavily negotiated and the parties have provided for specific rules which apply should a party become insolvent.
- High-value construction contracts: Until 30 June 2013, the stay will not apply to certain construction arrangements valued over A$1 billion. This includes arrangements for the provision of building work, construction work or the provision of related goods and services (including subcontracts). This transitional period recognises the complex nature of large scale construction projects and is intended to provide certainty to counter-parties regarding the operation of the ipso facto regime, while allowing time to consider how to structure affected arrangements in the future. The $1 billion threshold is intended to be tested against the value of all payments made under all arrangements for the project.
In addition, certain contractual rights are excluded from the operation of the ipso facto laws, including:
- Rights of set-off: allows for the netting of offsetting claims
- Step-in rights to perform the other party’s obligations: This enables the contact to remain on foot while the services continue. Provided the contract allows it, the exclusion allows agency to appoint a third party operator to take over.
What does it mean for you?
Key takeaways for agencies:
- The restriction on the right to terminate will mean that an agency will need to engage with the company/external administrator once the insolvency event occurs. Indeed, this is a key outcome sought by the reform.
- The scope of the exclusions, particularly for Government agencies, mean that agencies may still be able to exercise termination rights for contract party insolvency.
- The ability to terminate for substantive breach remains. Therefore, counterparty risk can be mitigated through robust contract management, performance breach monitoring and financial health checks on key suppliers.
- Risks associated with a party seeking to terminate stayed rights means that all contract termination of an insolvent counterparty should be signed off by your legal team.
- The scope of anti-avoidance provisions mean that ‘tricky’ drafting solutions designed to enable a party to terminate for the reason of the insolvency event breach, even with the ipso facto laws, should not be relied on. The amendments are made to Parts 5.1, 5.2 and 5.3A of Chapter 5 of the Corporations Act (the external administration provisions), and were contained in Treasury Laws Amendment (2017 Enterprise Incentives No.2) Act 2017 (Cth)