Ipso Facto Insolvency Reforms & Managing Insolvency Risks in Contracts By Philip Bambagiotti

1. One finds Ipso Facto clauses in most commercial contracts, usually those that involve the rendering of service over time. They have a useful and important role in reducing the risk of the effects of insolvency. However, as of 1 July 2018, the amendments to the Corporations Act 2001 (CA) by the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017, means that, as far as companies are concerned, ipso facto clauses have effectively been neutralised. Which gives rise to the question: what do we do now?

Ipso Facto Clauses

2. An ‘ipso facto clause, in the present context is a clause that provides a party to the contract with a right, usually to terminate but it can extend to some other things, on the happening of a particular event, in this case, the other party’s insolvency. That is, the right to terminate arises solely and automatically from the fact of the other party’s insolvency.

3. These clauses are ordinarily found in default or termination clauses. For example:

‘If the contractor … becomes bankrupt, assigns assets for the benefit of creditors generally, makes a composition or other arrangement with creditors, or, if the contractor is a company, goes into liquidation or receivership or is otherwise without full capacity...the owner may … terminate the contract.’

4. However, identification might well require consideration of the definitions. For example, the contract may provide for termination in the event of the ‘Contractor’s Default’, with the ‘Contractor’s Default’ set out at length in the definitions. These might include a lurid list of unsatisfactory behaviour, but in that list might include reference to an event, such as:

‘if an insolvency event happens in relation to the contractor’

5. An ‘insolvency event’ (whether described using that term, or spelt out) usually involves the range of events or activities that Chapter 5 CA addresses in the context of insolvency and winding up companies. These include: the appointment of a receiver (either generally or of a specific asset), the appointment of a voluntary administrator, other sorts of administrator (however described or however defined), a provisional liquidator, a liquidator, and the like.

6. An example of an ipso facto clause:

25: If the contractor:

• becomes bankrupt, assigns assets for the benefit of creditors generally, make a composition or other arrangement with creditors or, if the contractor is a company, goes into liquidation or receivership or is otherwise without full capacity

the owner may, if such default can be remedied, notify the contractor in writing that unless the default is remedied within 10 business days or such longer period as specified, the owner will terminate the contract.

7. Ipso facto clauses are used to quickly and painlessly allow the other party to avoid the cost, delay, and inconvenience of being saddled with contractual obligations with an insolvent party. To push, as far as possible, the consequences of insolvency back onto the insolvent party.

8. The need to quarantine the effect of the insolvency of a party involves more than simply that the insolvent party is not just that the other party has no money to pay its debts or to fund its operations.

9. It extends to, in the case of receivership and administration, restricting or freezing the rights of other people (including the owner of the land) over property that happens to be ‘used or occupied by, or in the possession of’ the company in administration, see sec 440B CA, and, in practical terms, forcing them to have to bargain with the administrator, who has the upper hand in every sense, to get access to their property.

10. Administration, and the similar states to insolvency found in Chapter 5 ‘External Administration’ CA can have a devastating effect on those third parties’ own activities. If a project stops progress, or if a party cannot get access to income earning property in order to use, to let, or to sell, can lead to further economic loss, and in some instances, even insolvency to those third parties.

11. In modern commerce, time is money, so where the CA provides a moratorium on enforcement action or even on recovery of possession of property, that necessarily involves money – and sometimes a lot of it.

What the Ipso Facto provisions of the CA do.

12. As is clear from the description of ipso facto clauses, they are designed to bring a swift, almost peremptory, end to the contract. And with it, in most cases, the company’s principal body of business, its intangible asset in the chose in action in the contract, and any prospect of using that contract as a means for the company to recover.

13. As the economic environment of companies gets tighter and tighter, 5 phenomena emerge:

1 There is more insolvent trading in the market.

2 Banks tighten credit;

3 Payment times get longer and longer, slowing cash flow, and amplifying the financial stress;

4 Boards, acting prudently, or merely acting in self-interest, trigger insolvency relief – there are more voluntary administrations etc.

5 More contracts, and so projects, terminate through the ipso facto clauses.

14. The cost to the economy of insolvency relief is very high. Liquidators are not cheap. Where activity ceases, staff become unemployed and lose the payroll for circulation. Suppliers lose with the drop in orders as well as payments for their invoices ceasing.

15. The focus of insolvency regulation in the Corporations Act 2001 (Cth) is both to weed out hopeless companies by liquidating them. This occurs partly because of the prohibition against insolvent trading. A parallel objective is to assist good businesses that are in temporary difficulty to recover. This, largely, is the intention of the voluntary administration provisions.

16. The Inquiry Report: Business Set-Up, Transfer and Closure (Productivity Commission, 30 September 2015) noted that with the tightening economic environment, directors, mindful of avoiding liability for insolvent trading, were pushing companies into administration earlier and earlier, even when a careful strategy may have avoided administration entirely.

17. It also noted that, with the popularity of the ipso facto clauses, with the administration, the contracts ended, blotting out any prospect of recovery – needlessly pushing good companies into oblivion.

18. Two of the report’s recommendations: introducing a ‘safe harbour’ regime – reducing the risk upon directors when the company’s solvency starts to slide, by giving them protection if they take prudent steps, such as to engage an ‘insolvency professional’ to advise. The second was to control the ipso facto clauses.

19. To that end, the ipso facto provisions are similar to the moratorium in Chapter 11 of the US Bankruptcy Code, sec 365(e)(1).

20. The ipso facto provisions in the Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017 came into effect on 1 July 2018, and affect contracts made after that date. That Act introduced sec 415D-F and 451E-G into the Corporations Act. These provisions are:

415D Stay on enforcing rights merely because of a proceeding under this Part etc.

Stay on enforcing rights

(1) A right cannot be enforced against a body for:

(a) the reason that the body, if it is a disclosing entity, has publicly announced that it will be making an application under section

411 for the purpose of avoiding being wound up in insolvency; or

(b) the reason that the body is the subject of an application under section 411; or

(c) the reason that the body is the subject of a compromise or arrangement approved under this Part as a result of an application under section 411; or

(d) the body’s financial position, if the body is the subject of such an announcement, application, compromise or arrangement; or

(e) a reason, prescribed by the regulations for the purposes of this paragraph, that relates to:

(i) the making, or possible making, of such an announcement, application, compromise or arrangement about the body; or

(ii) the body’s financial position;

if such an announcement, application, compromise or arrangement is later made about the body; or

(f) a reason that, in substance, is contrary to this subsection;

if the right arises for that reason by express provision (however described) of a contract, agreement or arrangement.

Period of the stay

(2) The right cannot be enforced as described in subsection (1) during the period (the stay period) that:

(a) starts:

(i) if the body makes an announcement referred to in paragraph (1)(a)—when the announcement is made; or

(ii) otherwise—when the application under section 411 is made; and

(b) ends:

(i) if the body makes an announcement referred to in paragraph (1)(a), and fails to make the announced application within the next 3 months or within any period ordered under subsection (3) for the body—at the end of the longer of those periods; or

(ii) when the application under section 411 is withdrawn or when the Court dismisses the application; or

(iii) unless subparagraph (iv) applies—at the end of any compromise or arrangement approved under this Part as a result of the application under section 411; or

(iv) if such a compromise or arrangement ends because of a resolution or order for the body to be wound up—when the body’s affairs have been fully wound up.

(3) The Court may order a longer period than the 3 months otherwise applying under subparagraph (2)(b)(i) for the body if the Court is

satisfied that the longer period is appropriate having regard to the interests of justice.

Enforcing rights after the stay for reasons relating to earlier circumstances

(4) The right is unenforceable against the body indefinitely after the end of the stay period to the extent that a reason for seeking to enforce the right:

(a) is the body’s financial position before the end of the stay period; or

(b) is the body having been the subject of any of the following before the end of the stay period:

(i) an announcement referred to in paragraph (1)(a);

(ii) an application under section 411;

(iii) a compromise or arrangement approved under this Part as a result of an application under section 411; or

(c) is a reason, prescribed by the regulations for the purposes of this paragraph, relating to circumstances in existence during the stay period; or

(d) is a reason referred to in paragraph (1)(e) or (f).

Application must be made to avoid insolvency

(5) However, subsection (1) does not apply, and is taken never to have applied, if the application under section 411 fails to state that it is being made for the purpose of the body avoiding being wound up in insolvency.

Rights not subject to the stay

(6) Subsection (1) does not apply to the right if it is:

(a) a right under a contract, agreement or arrangement entered into after the day the order (if any) approving under this Part a compromise or arrangement as a result of the application takes effect; or

(b) a right contained in a kind of contract, agreement or arrangement:

(i) prescribed by the regulations for the purposes of this subparagraph; or

(ii) declared under paragraph (7)(a); or

(c) a right of a kind declared under paragraph (7)(b); or

(d) a right of a kind declared under paragraph (7)(c), and the circumstances specified in that declaration exist.

(7) For the purposes of subsection (6), the Minister may, by legislative instrument:

(a) declare kinds of contracts, agreements or arrangements referred to in a specified law of the Commonwealth; or

(b) declare kinds of rights to which subsection (1) does not apply; or

(c) declare kinds of rights to which subsection (1) does not apply in specified circumstances.

(8) If the application under section 411 results in the approval under this Part of a compromise or arrangement, subsection (1) does not apply to the right to the extent that:

(a) the person appointed to administer the compromise or arrangement; or

(b) if a liquidator of the body is appointed after the start of the stay period—the liquidator;

has consented in writing to the enforcement of the right.

Stay on body’s right to new advance of money or credit

(9) If:

(a) one or more rights of an entity cannot be enforced against a body for a period because of subsection (1); and

(b) the body has a right under a contract, agreement or arrangement against the entity for a new advance of money or credit;

that right of the body cannot be enforced during the same period.

415E Lifting the stay

(1) The Court may order that subsection 415D(1) does not apply for one or more rights against a body if the Court is satisfied:

(a) that the relevant compromise or arrangement:

(i) to be applied for; or

(ii) applied for; or

(iii) approved;

under this Part is not for the purpose of the body avoiding being wound up in insolvency; or

(b) that this is appropriate in the interests of justice.

(2) The order may also provide that the holder of those rights may choose to enforce those rights from the earlier of:

(a) the day any announcement referred to in paragraph 415D(1)(a) was made by the body; and

(b) the day any application under section 411 was made for the compromise or arrangement.

(3) An application for the order may be made by the holder of those rights.

415F Order for rights to be enforceable only with leave of the Court

Orders

(1) The Court may order that one or more rights under a contract, agreement or arrangement are enforceable against a body only:

(a) with the leave of the Court; and

(b) in accordance with such terms (if any) as the Court imposes.

(2) The Court may make the order (the stay order) if:

(a) the body is the subject of any of the following:

(i) an announcement referred to in paragraph 415D(1)(a);

(ii) an application under section 411 (the section 411 application);

(iii) a compromise or arrangement approved under this Part as a result of a section 411 application; and

(b) the Court is satisfied that:

(i) the rights are being exercised; or

(ii) the rights are likely to be exercised; or

(iii) there is a threat to exercise the rights;

because of one or more reasons referred to in paragraphs 415D(1)(a) to (f); and

(c) an application for the stay order is:

(i) if the body has made an announcement referred to in paragraph 415D(1)(a), but not yet a section 411 application—made by the body; or

(ii) if the body has made a section 411 application, but a resulting compromise or arrangement is yet to be approved under this Part—included in the section 411 application; or

(iii) if a compromise or arrangement has been approved under this Part as a result of the section 411 application—made by the person appointed to administer the compromise or arrangement; and

(d) in a case where the body has made a section 411 application—the section 411 application states it is being made for the purpose of the body avoiding being wound up in insolvency.

(3) A stay order must specify the period for which it applies. In working out the period, the Court must have regard to:

(a) subsections 415D(2), (3) and (4); and

(b) the interests of justice.

(4) Subsection (1) does not apply to a right referred to in subsection 415D(6) or (8).

Interim orders

(5) Before deciding an application for a stay order, the Court may grant an interim order for one or more rights under a contract, agreement or arrangement not to be enforced against a body.

(6) The Court must not require an applicant for a stay order to give an undertaking as to damages as a condition of granting an interim order.

415FA Self-executing provisions

(1) The object of subsection (2) is to ensure that a self-executing provision:

(a) cannot start to apply against a body for certain reasons; and

(b) can be the subject of a Court order providing that the provision can only start to apply against a body with the leave of the Court, and in accordance with such terms (if any) as the Court imposes.

(2) Sections 415D to 415F also apply in relation to a self-executing provision in a corresponding way to the way they apply in relation to a right. For this purpose, assume those sections apply with such modifications as are necessary, including any prescribed by the regulations for the purposes of this subsection.

(3) In this section:

self-executing provision means a provision of a contract, agreement or arrangement that can start to apply automatically:

(a) for one or more reasons; and

(b) without any party to the contract, agreement or arrangement making a decision that the provision should start to apply.

And

451E Stay on enforcing rights merely because the company is under administration etc.

Stay on enforcing rights

(1) A right cannot be enforced against a company for:

(a) the reason that the company has come or is under administration; or

(b) the company’s financial position, if the company is under administration; or

(c) a reason, prescribed by the regulations for the purposes of this paragraph, that relates to:

(i) the company coming, or possibly coming, under administration; or

(ii) the company’s financial position;

if the company later comes under administration; or

(d) a reason that, in substance, is contrary to this subsection;

if the right arises for that reason by express provision (however described) of a contract, agreement or arrangement.

Period of the stay

(2) The right cannot be enforced as described in subsection (1) during the period (the stay period) starting when the company comes under administration and ending at the latest of the following:

(a) when the administration ends;

(b) if one or more orders are made under subsection (3) for the company as the result of an application made before the administration ends—when the last made of those orders ceases to be in force;

(c) if the administration ends because of a resolution or order for the company to be wound up—when the company’s affairs have been fully wound up.

(3) The Court:

(a) may order an extension of the period otherwise applying under subsection (2) for the company if the Court is satisfied that the extension is appropriate having regard to the interests of justice; and

(b) before deciding an application for an order under paragraph (a), may grant an interim order, but must not require the applicant to give an undertaking as to damages as a condition for doing so.

Enforcing rights after the stay for reasons relating to earlier circumstances

(4) The right is unenforceable against the company indefinitely after the end of the stay period to the extent that a reason for seeking to enforce the right:

(a) is the company’s financial position before the end of the stay period; or

(b) is the company having come or been under administration before the end of the stay period; or

(c) is a reason, prescribed by the regulations for the purposes of this paragraph, relating to circumstances in existence during the stay period; or

(d) is a reason referred to in paragraph (1)(c) or (d).

Rights not subject to the stay

(5) Subsection (1) does not apply to the right if it is:

(a) a right under a contract, agreement or arrangement entered into after the company comes under administration; or

(b) a right contained in a kind of contract, agreement or arrangement:

(i) prescribed by the regulations for the purposes of this subparagraph; or

(ii) declared under paragraph (6)(a); or

(c) a right of a kind declared under paragraph (6)(b); or

(d) a right of a kind declared under paragraph (6)(c), and the circumstances specified in that declaration exist.

(6) For the purposes of subsection (5), the Minister may, by legislative instrument:

(a) declare kinds of contracts, agreements or arrangements referred to in a specified law of the Commonwealth; or

(b) declare kinds of rights to which subsection (1) does not apply; or

(c) declare kinds of rights to which subsection (1) does not apply in specified circumstances.

(7) Subsection (1) does not apply to the right to the extent that:

(a) the administrator of the company; or

(b) if a liquidator of the company is appointed after the administration ends—the liquidator;

has consented in writing to the enforcement of the right.

Stay on company’s right to new advance of money or credit

(8) If:

(a) one or more rights of an entity cannot be enforced against a company for a period because of subsection (1); and

(b) the company has a right under a contract, agreement or arrangement against the entity for a new advance of money or credit;

that right of the company cannot be enforced during the same period.

451F Lifting the stay

(1) The Court may order that subsection 451E(1) does not apply for one or more rights against a company if the Court is satisfied that this is appropriate in the interests of justice.

(2) An application for the order may be made by the holder of those rights.

There are, thereafter provisions, sec 415FA providing more detail as to ‘self-executing provisions’.

451G Order for rights to be enforceable only with leave of the Court

Orders

(1) The Court may order that one or more rights under a contract, agreement or arrangement are enforceable against a company only:

(a) with the leave of the Court; and

(b) in accordance with such terms (if any) as the Court imposes.

(2) The Court may make the order if:

(a) the company is under administration; and

(b) the Court is satisfied that:

(i) the rights are being exercised; or

(ii) the rights are likely to be exercised; or

(iii) there is a threat to exercise the rights;

because of one or more reasons referred to in paragraphs 451E(1)(a) to (d); and

(c) an application for the order is made by the administrator of the company.

(3) An order under subsection (1) must specify the period for which it applies. In working out the period, the Court must have regard to:

(a) subsections 451E(2), (3) and (4); and

(b) the interests of justice.

(4) Subsection (1) does not apply to a right referred to in subsection 451E(5) or (7).

Interim orders

(5) Before deciding an application for an order under subsection (1), the Court may grant an interim order for one or more rights under a contract, agreement or arrangement not to be enforced against a company.

(6) The Court must not require an applicant for an order under subsection (1) to give an undertaking as to damages as a condition of granting an interim order.

Summary of the Provisions

21. So in summary:

(a) Sec 415E-G relate to administrations and the like, sec 451E-G are directed specifically to deed of company arrangement schemes.

(b) Sec 415D(1) is cast in general terms: ‘a right cannot be enforced’ for the ‘stay period’: sec 415D(2), which effectively covers the period of administration.

(c) The stay period can be extended, sec 415D(3), and, in practice, the restraint on enforcement is very likely to be indefinite, sec 415D(4).

(d) The operation of the provisions are subject to the numerous exceptions, generally as set out in Part 5.3A.50 Corporations Regulation 2001.

(e) In addition to these, the provisions will not apply to a contract made before 1 July 2018: sec 3, Schedule 1 cl 17, Treasury Laws Amendment (2017 Enterprise Incentives No 2) Act 2017.

(f) The provisions apply to a right ‘however described’, which puts application of the provisions to substance, so they cannot be defeated by form.

22. The range of exceptions is substantial, and generally relate to financing and securities arrangements, a wide range of government contracts, larger scale contracts involving sophisticated parties etc.

23. In particular, certain work that is otherwise covered by the Building & Construction Industry Security of Payments Act 1999 NSW, para 5(1)(d) and (f) is excluded. Those sections relate to cleaning of buildings in the course of construction and painting etc.

24. The list of contract types is in Reg 5.3A.50(2) Corporations Regulations 2001 and include:

(a) contracts issued by the Commonwealth, a State, or a Territory, a government authority of these or a local government, at (b).

(b) Contracts relating to national security, public hospitals (c) and (d);

(c) Contracts for the ‘supply of essential or critical goods or services’: (f);

(d) Contracts related to a derivative (g), securities financing (h), underwriting financial products (j), and financial products (k);

(e) Contracts for the sale of a business, (m);

(f) And importantly, a ‘contract’ being a novation, assignment, or a variation of a contract made before 1 July 2018 (zn).

So what to do?

25. Because the ipso facto provisions in the Corporations Act are directed to ‘rights’ and the ‘enforcement of rights’, they will not invalidate or render void or voidable contractual provisions. Most contracts, in any event, have a severability clause that would protect the balance of the contract in any event.

26. So there is no prejudice arising from the use of older standard forms that include such clauses, except to the extent that they become misleading – for conferring rights that are unenforceable.

27. The ipso facto provisions are very carefully and tightly drawn, even in the light of the anti-avoidance aspects of those provisions. What they attack are the clauses giving the other party a power to terminate, suspend, or otherwise act where that right arises from the fact of insolvency action.

28. They do not affect the powers of the other party to terminate, suspend, etc on other grounds – for example, for default or breach arising from a failure to prosecute the work or to delay performance.

29. Often (but not always), the administration of a contractor follows a period of non-compliance with contractual obligations. The cash-flow stresses are seen early on, with delays in paying sub-contractors and materials, dwindling of staff numbers, derogation in quality of work (as workers become more focussed upon their pay cheques than the work itself) and so on.

30. With the neutering of the ipso facto clauses in a contract, the process of termination of a delinquent contractor can become longer – usually the contracts contain show cause provisions and the like. Vigilance can see the early signs.

31. However, this heightens the need for caution. The ipso facto provisions, eg sec 451E(1)(d) extends the reach of the provisions to ‘a reason that, in substance, is contrary to this subsection’. So one cannot simply dress up termination because of administration as a termination because of fault, unless the fault is real and justifiable.

32. Equally, the anti-avoidance provisions such as sec 415D(1)(f) and 451E(1)(d) having the reach, have the potential to make a insubstantial termination for ‘fault’ into a repudiation of contract, if the bases of the termination right relied upon are effectively unenforceable.

33. In order to avoid those kinds of consequence, the prudent parties will:

(a) In a case in which the activity involves a mass of interweaving contracts, take careful note of which are affected by the ipso facto provisions and which are not, so that any knock-on effects can be prepared for;

(b) Make sure that termination rights for other reasons, such as default, are clear with clearly spelt out triggering criteria;

(c) Increase the level of oversight and contract management on site, so that the early strains that ultimately lead to insolvency can be picked up, and acted upon, early – and so to avoid the suggestion that the later termination is a sham;

(d) Be careful to conduct the contract diligently, so that rights of termination, taking control of the site, appointing replacement contractors etc, are not waived, and are exercised at an early stage.

(e) With default clauses, shorten the periods for show cause, and regularise or regulate the show cause provisions, so that the other party is not left in limbo for a period, during which the administration may have begun.

34. Managing insolvency risk becomes more challenging with the ipso facto provisions, but not necessarily more difficult.

35. Due diligence and proper scrutiny of contracting parties has always been desirable, but is perhaps, now, necessary.

36. Also, the present environment provokes the need to have the difficult conversations in the course of contract negotiation. For retentions, third party securities including guarantees etc, and for a more pragmatic approach to indemnities – to the extent that these fall outside of the ipso facto regime.

37. What the provisions do, however, will be to sharpen to hair triggers the termination and default rights and provisions in contracts. This will mean that more contracts will roll into dispute and contractual termination than was previously the case, because there will necessarily be less tolerance for delay and non-fulfilment of obligations. This is unfortunate, but is a necessary consequence of the ‘indulgence’ given to stressed companies by the legislation.

38. In short, the provisions give rise to the heightened need for vigilance and a practical and pragmatic approach to contracting – which simply means that taking more care will repay the effort.

Liability limited by a scheme approved under the Professional Standards Legislation

This paper is presented for academic discussion and consideration only, and does not contain legal

advice and should not be relied upon to that effect. Any and all of the statements contained herein

should be verified before being relied upon. Copyright and moral rights of authorship are retained

to the author. This paper is not to be reproduced without my consent.

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