Australia: Sit, stay, roll over! – Reforms in the treatment of ipso facto clauses in contracts

The Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017 (Amending Act) received royal assent on 18 September 2017. The Amending Act was designed to encourage a ‘turnaround culture’ in Australian companies by removing some of the barriers to restructuring faced by struggling companies and their directors.

Part 2 of Schedule 1 of the Amending Act introduced amendments to the Corporations Act 2001 (Cth) (the Act) which impose a stay on ‘ipso facto’ clauses in agreements. The stay will come into effect on 1 July 2018, and will apply to all contracts, agreements or arrangements entered into from 1 July 2018 onwards.

This article explains what an ‘ipso facto’ clause is, how these clauses are problematic for companies that are struggling or that have entered into administration, and what the stay on ipso facto clauses will mean for Australian companies.

What is an ‘ipso facto’ clause?

An ‘ipso facto’ clause is a clause in an agreement that:

  • allows one party to terminate an agreement when an insolvency event occurs with respect to the other party; or
  • has a result of automatically terminating the agreement when an insolvency event occurs with respect to a party (a ‘self-executing’ clause).

What constitutes an ‘insolvency event’ will depend on how the ipso facto clause is drafted and will vary from agreement to agreement. Insolvency events can include diverse matters such as a company appointing a voluntary administrator, a company entering into liquidation, a company entering into a scheme of arrangement with its creditors, or the time limit lapsing on a statutory demand issued against a company. Ipso facto clauses are most often relied upon in cases of administration or liquidation, because it is easier to prove that these events have occurred and because the other party would typically be aware of such events.

Purpose of ipso facto clauses

Ipso facto clauses serve a real commercial purpose in agreements for the party that is not subject to the insolvency event (Solvent Party). An ipso facto clause acts as a risk management tool for the Solvent Party, providing them with options if the other party to the agreement is in financial distress. An ipso facto clause helps to protect the Solvent Party from the following risks:

  1. incurring further debts with a company that is not or may not be in a position to pay those debts; and
  2. receiving further payments from a company that may become the subject of argument with that company’s liquidator or administrator in any preferential payment claims.

Why are ipso facto clauses a problem?

A company that is struggling or that has already entered into administration relies strongly on its existing key contracts in order to stay in business and to, hopefully, turn its position around and become profitable again.

Ipso facto clauses make it much more difficult for a company to turn its fortunes around, and thus will also often result in a less desirable outcome for the company’s creditors. This is because:

  1. if one or more of the company’s key contracts are terminated in reliance on an ipso facto clause, the company will lose its revenue and its ability to turnaround its position will be significantly reduced; and
  2. even if the other party to the agreement does not terminate the agreement, the threat of the ipso facto clause gives them an unfair amount of leverage over the company. The company will then be left in a position of being required to negotiate with the other party to the other party’s advantage in order to keep that party’s business.

What does the Amending Act do?

The Amending Act addresses the problem of ipso facto clauses by preventing the parties to an agreement from relying on the rights granted by such clauses in certain circumstances where the company is undertaking a formal restructure that is due to the company’s financial position or entry into formal restructure.

The Amending Act introduces three broad provisions to the Act:

  1. Section 415D of the Act prevents a person from exercising an express right (imposes a stay) where the basis for that right is that a company has made, has announced that it will make, or will make an application to enter into a scheme of company arrangement pursuant to section 411 of the Act. The stay ends after 3 months if a section 411 application is subsequently not made, when a section 411 application is dismissed, when the scheme of arrangement ends, or, if a resolution or order is made to wind up the company, when the company is finally wound up.
  2. Section 434J(1) imposes a stay where a managing controller is appointed over the whole or substantially the whole of a company’s property. The stay ends when the managing controller’s control of the property ends.
  3. Section 451E(1) imposes a stay where a company is under administration or may come under administration. The stay ends when the administration ends, or when the company is fully wound up if an order or resolution is made that the company be wound up.

Pursuant to sections 415FA, 434LA and 451GA, each of the stays set out above also apply to self-executing clauses.

In addition to the specific circumstances of schemes of arrangement, appointment of a managing controller and administration, the stay provisions apply to any circumstances where a party might seek to rely upon an ipso facto clause that are ‘in substance’ contrary to the provisions. This means that the provisions cover a wide range of circumstances and will apply to the majority of circumstances in which ipso facto clauses have been used in the past.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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