On 18 September 2017, major reforms to Australia’s insolvency laws were passed making ipso facto clauses unenforceable in certain insolvency procedures. This article provides an overview of the reasons for the reform, when the laws will take effect, how the new laws should operate and how they will impact the construction industry.
The new laws will prevent a principal’s ability to rely on a contractor’s insolvency event to enforce common ipso facto clauses, including the right to terminate the contract, the right to take work out of a contractor’s hands or the right to call upon retention monies or bank guarantees. This is good news for contractors, who will still be able to receive benefits under the contract whilst in administration, providing them with an opportunity to turn their business around.
Ipso facto clauses allow one party to terminate or modify the operation of a contract when a specific event occurs, whether or not the counterparty otherwise continues performance of the contract. For example, many construction contracts allow for the principal to terminate the contract or take work out of the contractor’s hands if the contractor enters into voluntary administration or becomes insolvent, regardless of whether the contractor continues to perform work under the contract. Naturally, ipso facto clauses can have damaging consequences for the party suffering an insolvency-related event and can have a snowball effect on its financial position, which in turn reduces the ability of companies to successfully restructure.
Legislative reforms were called for, resulting in the Federal Government’s Treasury Laws Amendment (2017 Enterprise Incentives No 2) Bill 2017 (Cth), which has been introduced to promote a culture of entrepreneurship and innovation, and move the focus of insolvent trading laws away from stigmatising and penalising failure.1
Prevention from relying on ipso facto clauses
The new provisions, which will commence no later than 30 June 2018, will prevent a party from relying on certain ipso facto clauses that are adverse to insolvent parties (including the immediate right to terminate for an insolvency event) if the reason for trying to enforce the right is because of:
- the company entering or being under administration;
- the company’s financial position, if the company is under administration; or
- a reason that relates to the company’s financial position or the possibility of it entering or being under administration.
Contracting parties will be prevented from relying on ipso facto clauses for the above reasons from the moment the company enters into administration, until the administration ends, unless:
- the company is being wound up, in which case the prevention period will apply until the company is fully wound up; or
- the company makes an application to the Court to extend the prevention period, in which case the prevention period will end if the application is withdrawn or rejected, or the Court accepts the application, and that extension period runs out.
Once the prevention period ends, a party is not allowed to retrospectively rely on the insolvency event that brought about the prevention period to later try to enforce a relevant ipso facto clause.
Impact on the construction industry
The reforms will have a significant impact on construction contracts. A principal will no longer be able to rely on a counterparty’s insolvency to enforce clauses that give rise to:
- the right to terminate;
- the right to take work out of a contractor’s hands; and
- the right to call upon a bank guarantee or other security.
However, any right to terminate under the contract that is outside the parameters of the ipso facto clause, such as a right to termination due to breach, default, non-payment or non-performance, remains enforceable.
The new ipso facto provisions are generally good news for contractors and subcontractors. Under the current laws, where a contractor is prepared to work through a voluntary administration, but the principal terminates the contract, this can have a very negative effect on the voluntary administration and the debtors. The new ipso facto provisions will allow contractors/subcontractors to still receive benefits for contracts that remain on foot (notwithstanding entering, for example, voluntary administration). The goal is that these contractors will be able to trade out of insolvency if they retain the benefit of existing contracts.
Owners and principals will need to carefully consider contractual clauses that deal with termination, insolvency, breach, retention and security to ensure that their interests are protected to the extent permissible under the new legislation. For example, it may be possible to expand on performance requirements or events of default in order to lower risk. It may also be appropriate to consider extending existing contracts after the new laws commence, instead of entering new contracts. This is because the new provisions will only affect contracts entered into after the commencement of the reforms, so any ipso facto provisions that already exist in the contract can still be enforced.
These changes are a significant policy shift from the previous regime, and require a rethink in construction contract drafting, particularly for contracts entered into for projects after 1 July 2018 (or sooner if the Act is proclaimed earlier). A carefully drafted contract that addresses the potential risks to the company is the best way to protect your company’s interests against undue economic pressure that can occur if a counterparty enters voluntary administration or other event that will prevent the use of ipso facto clauses, particularly the right to terminate.
1 Explanatory Memorandum, Treasury Laws Amendment (2017 Enterprise Incentives No 2) Bill 2017 (Cth), p. 3.