Most construction contracts provide a right of termination on the occurrence of an insolvency event. An insolvency event is usually defined broadly to include not only actual insolvency, but also those stages leading up to a potential insolvency, including administration and receivership. These clauses are called 'ipso facto' (meaning 'by that very fact or act') as they provide a fact based trigger for termination rather than one based on default.
The main benefit of these ipso facto clauses is that it gives the terminating party freedom to exit a contract as soon as insolvency becomes a real risk, rather than waiting until it actually happens, by which time it is likely to have suffered actual losses as well as having to deal with a contractual counter-party in distress. Such distress can lead to one or more adverse consequences including:
- non-payment of workers and subcontractors which can leave you exposed to a disenfranchised team working on your project
- increased risk taking and low compliance in, for example, Work Health and Safety, Environmental and Quality.
However from 1 July 2018, reforms to the Corporations Act 2001 (Cth) means that ipso facto clauses will be ineffective in the event that the counterparty becomes insolvent, has a managing controller appointed, or goes into administration. These new laws are part of significant changes to the insolvency laws under the Safe Harbour provisions (some of which are in effect now) that provide protection for the Directors of the insolvent party.
The main policy rationale for these laws is to better enable companies in some financial distress to have a chance of 'trading out' of their situation rather than necessarily going into actual insolvency (liquidation).
So what do the new reform measures do?
The reform measures enact a 'stay' on the contractual right to enforce a number of contractual measures against the distressed company. The contractual measures affected are the right to:
- terminate the contract
- modify the contract
- call in bank guarantees
- step into the contract
- suspend the works.
The regulators have identified that triggering any of the above rights has a serious negative impact on a company's ability to trade out of its predicament, thus increasing the likelihood that it will continue to remain insolvent or be wound up.
Is there a way to contract out of the new laws?
The new laws cannot be contracted out of. On the second reading of the bill passing the Act, regulatory powers were established to prevent parties from contracting out of the new ispo facto provisions. In the event that the laws do not capture contractual clauses that attempt to circumvent the new provisions, the Government will have regulatory powers to intervene and prevent these clauses from being enforceable. These new laws will apply to new contracts entered into from 1 July 2018, but will not be retrospective. Whether they will apply to extensions or variations of contracts pre-dating these changes (similar to the Small Business Unfair Contract Terms legislation that came into effect in November 2016) remains to be seen.
Does this completely remove the utility of ipso facto clauses from construction contracts?
It is not the case that all ipso facto clauses should be removed from our construction contracts, and they continue to be relevant, as the new laws:
- will not apply to existing contract
- can only provide protection where a company restructure is ongoing. In the event that a company has fallen into receivership or liquidation, the former ipso facto rights will still be enforceable (as they are now).
- Provide the administrators and the counterparty, the ability to make an arrangement lifting the 'stay' on the exercise of the contract power and enforcing the rights under the ipso facto clauses in any event.
- Allow the affected counterparty to apply to the Federal Court to have the stay lifted where it is appropriate in the interests of justice (for example if not allowing the stay would be lifted may present a real risk of insolvency to the party seeking the stay).
What can you do?
This further intervention in freedom to contract will affect all sectors, but perhaps the construction and infrastructure sector will be affected the most, particularly in light of other legislative contract restrictions including:
- the Security of Payment regime
- the Personal Property and Securities legislation and the potential impact it has on construction contracts and projects
- the Small Business laws (referred to above and the subject of an earlier article here).
Parties to contracts should as soon as possible:
- gain a thorough understanding of the new laws, and the impact they will have on their contracts and their business
- put in place effective measures around counterparty selection to minimise the risk of counterparty insolvency occurring in the first place (such as reference checking, PPSR checks, third party financial reports, scrutiny of current financial position etc)
- bolster contractual rights that are unaffected by these new laws (such as parent company guarantees, deeds of guarantee, undertaking and substitution, direct payment of subcontractors, rights to inspect current financials at any time during the contract etc)
- consider effective ways of identifying a company that may be heading to financial distress before the 'stay' takes effect (i.e. prior to receivership / administration) so that the ipso facto clauses can still be used
- ensure a termination for convenience right is in your contract (for situations where you are able to identify financial distress prior to the 'stay' taking effect).
This publication does not deal with every important topic or change in law and is not intended to be relied upon as a substitute for legal or other advice that may be relevant to the reader's specific circumstances. If you have found this publication of interest and would like to know more or wish to obtain legal advice relevant to your circumstances please contact one of the named individuals listed.