21 September, 2017
Corporations Act changes may prevent the exercise of termination rights linked to insolvency events.
What you need to know
On 12 September 2017 the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth) (Act) was passed by the Commonwealth Parliament.
The Act amends the Corporations Act 2001 (Cth) (Corporations Act) to include new statutory restrictions which prevent a counterparty (such as the Commonwealth) from exercising contractual rights (including a right to terminate) on the basis that the other party suffers certain types of insolvency events.
The purpose of the new restrictions is to protect companies in financial difficulties that are undergoing genuine restructuring. For example, it would prevent a counterparty (such as the Commonwealth) from terminating a contract merely because the contractor has elected to go into voluntary administration.
Importantly, the Act does not make contractual rights to terminate unlawful. However, Commonwealth agencies should:
- be proactive in managing contracts and alive to the risk that a contractor may be in financial difficulty;
- seek legal advice before exercising contractual rights (particularly rights to terminate) on the basis of an actual or possible insolvency event;
- review their templates to ensure there are clear contractual rights to terminate for poor performance that are not linked to insolvency events; and
- review their templates, including to make provide that they are not required to make milestone or other payments (other than for goods or services that have been delivered) while they are prohibited from exercising rights because of the new restrictions.
Background
It is common for Commonwealth contracts and funding agreements to give the Commonwealth a right to terminate the contract for default where the other party is insolvent or enters into a form of "external administration". For example, the Department of Defence ASDEFCON templates include a right to terminate if an "Insolvency Event" occurs in relation to the Contractor. This concept is defined broadly to include:
- the appointment of a liquidator or other controller;
- the person becoming subject to external administration provided for in Chapter 5 of the Corporations Act;
- the person suffering execution against, or a secured creditor taking possession of any of the person's property;
- the person being taken to have failed to comply with a statutory demand; and
- an order or resolution for the winding up or deregistration of the person.
The Explanatory Memorandum describes these types of provisions as 'ipso facto' clauses because they allow one party to terminate because of a particular fact (ie, that the other party is insolvent), regardless of whether or not the other party is still ready, willing and able to perform the contract.
'Ipso facto' clauses are designed to avoid the situation where an insolvency event has occurred in relation to the contractor and the counterparty is required to wait for the insolvency process to run its course before it can act. If a contractor is placed into administration, the administrator will need time to assess the financial position of the contractor and determine whether or not it will be possible for the contractor to continue as a going concern, or will need to be wound up by a liquidator. The counterparty may have lost all confidence in the contractor and wants to act quickly to engage a replacement contractor to ensure any delay or interruption in performance is minimised.
The concern from insolvency practitioners is that these types of provisions can damage the value of the contractor and undermine the insolvency process. That is, the termination of valuable contracts may significantly reduce the value of the business and make it difficult for the business to be restructured and/or sold to a new owner.
The Act seeks to address these concerns and limit the impact of these types of provisions. As noted in the Explanatory Memorandum:
2.4. The operation of ipso facto provisions can… reduce the scope for a successful restructure, destroy the enterprise value of a business entering formal administration or prevent the sale of the business as a going concern.
2.5. These outcomes can also reduce or eliminate returns in liquidation because they disrupt the businesses’ contractual arrangements and destroy goodwill, potentially prejudicing other creditors and defeating the purpose of a voluntary administration.
2.6. Entrepreneurs and private equity firms often invest in struggling companies with a view to making them profitable. The ability of a business’ suppliers, customers or other creditors to terminate a contract solely due to the financial position of the company or the commencement of a formal restructure increases uncertainty for the potential investor and makes the business a less attractive investment opportunity. As a result, the operation of ipso facto clauses may deter such investment, or reduce the price a potential investor is willing to pay for a business.
The Act had been referred to the Senate Economics Legislation Committee (Committee) and there were a range of submissions to the Committee in relation to the potential operation of the Act. The Committee recommended the relevant Bill be passed in its current form. The Committee noted that concerns had been raised in relation to the operation of the Act, but it resolved that these would be best clarified in regulations to be made under the Act. However, a number of amendments to the Act were subsequently made by the Senate. The purpose of these amendments were largely to strengthen anti-avoidance mechanisms and clarify that the new provisions apply to ipso facto clauses that are "self-executing" (ie they are automatic and do not require a party to trigger the right).
Impact of the reforms
Overview
Part 2 of the Act amends the Corporations Act to make contractual rights unenforceable (ie, there is a "stay" on enforcement) if any of the following types of external administration occur:
Under the new regime, a "right" cannot be enforced against a company where there is a scheme of arrangement, receivership or administration if:
- the right arises for that reason by express provision (however described) of a contract, agreement or arrangement.
- In other words, a counterparty (such as the Commonwealth) cannot "enforce" a right to terminate a contract, or seek damages, merely because the other party has entered into voluntary administration, a receiver or other managing controller has been appointed, or a scheme of arrangement has been announced.
- The restrictions do not apply to companies that are in liquidation (unless it was in voluntary administration before being liquidated) or engaged in insolvent trading. They also do not apply if the liquidator, administrator or person appointed to administer a scheme of arrangement has consented in writing to the enforcement of the right.
- The amendments made by the Senate expand the situations where a contractual right is prevented from being enforced. In particular, the new provisions prevent enforcement of a right that arises because of:
- a reason prescribed by the regulations that relates to the body's "financial position" or a "possible" making of an announcement, entering into receivership or voluntary administration if "later" this actually occurs; and
- a reason "that, in substance, is contrary to" the new provisions.
What happens if the right is unenforceable?
If a party to a contract (such as the Commonwealth) seeks to exercise a right to terminate (in circumstances where this right is unenforceable under the new provisions of the Corporations Act), the contractor (or the receiver or administrator acting as agent of the contractor) could potentially bring an action for damages on the basis that the party:
- wrongly repudiated the contract (given it had no enforceable right to terminate); and
- had no right to stop performing its obligations under the contract (given the contract was still on foot).
In each case, the contractor may itself be entitled to terminate the contract and seek damages.
Act only applies to new contracts
The new provisions inserted into the Corporations Act only applies to contracts made after the Act comes into force. As such, any rights linked to insolvency events that are included in existing contracts may still be able to be enforced despite the changes made under the Act.
Impact on other provisions of the contract
The new provisions are limited to contractual rights that arise because of the insolvency events described above. This means that they do not apply to rights to terminate for other reasons (eg, a failure to meet a payment or other obligation).
The new provisions would also not apply to a termination by agreement, a termination for convenience or a mutual right to terminate on notice for no cause.
However, the legislation includes the ability to make regulations in relation to rights that are triggered by other reasons.
The Explanatory Memorandum states that:
- The broad regulation making power to prescribe reasons to which the stay will apply has been included as an anti-avoidance mechanism to ensure the Government can respond to possible contracts or agreements that are drafted or prepared in a way to circumvent the provisions in [Part 2]. It is appropriate and necessary for this power to be in regulations so that the Government has the flexibility to respond quickly to ensure that the stay effectively applies to such contracts and agreements before they become widespread and negate these reforms.
Impact on payment arrangements
Under the new provisions, if a party is prevented from enforcing a contractual right (because of a scheme of arrangement, receivership or administration), the insolvent company cannot "enforce" any:
- right under a contract, agreement or arrangement against the entity for a new advance of money or credit
- This means that, while a bank or financial institution may not be able to terminate a loan facility agreement because of these insolvency events, it is nevertheless not required to make new loan advances to the insolvent company.
- It is unclear how this would apply to contractual payments that are not in the form of loan advances, for example where the payments are for the achievement of milestones under a procurement contract or funding agreement. However it is likely that any refusal by the Commonwealth to pay for goods or services that have been delivered (on the basis that it has concerns about future performance) would be a breach.
Impact on subcontracting arrangements
It will also be necessary to consider the impact of these changes on the subcontracting arrangements. The usual position is that a contractor takes responsibility for its subcontractors, including the impact of any insolvency event occurring in relation to its subcontractors. A contractor would usually accept this risk on the basis that it can manage the risk by ensuring it only enters into subcontracts with entities with sufficient financial capacity and by ensuring that it can terminate agreements with insolvent subcontractors and replace them with new subcontractors.
However, under the changes to the Corporations Act, the contractor may be prevented from terminating or replacing an insolvent subcontractor for the relevant period and this means the contractor may be taking on additional risk that it cannot easily manage. While the legislation allows the contractor to terminate a subcontractor during this period if it is not performing, it does not give the contractor clear rights to:
- terminate for anticipatory breach (ie, to assess the likelihood that the subcontractor will not be able to meet a future commitment); or
- start procuring a replacement subcontractor so that there is no gap in service provision if the subcontractor is unable to resolve the issue.
The Commonwealth may need to reconsider the risk allocation under its contracts, including whether or not it should continue to allocate the risk of subcontractor insolvency to its contractors in all cases.
The Commonwealth will also need to review any provisions which only give the contractor relief after it has terminated the insolvent subcontractor.
How long does the stay on enforcement last?
Unless extended by a court, a party will be prevented from enforcing contractual rights for the following periods:
| SCENARIO | STAY BEGINS | STAY ENDS |
|---|---|---|
| Scheme of arrangement | When the public announcement or the scheme application is made |
|
| Receivership or managing controller | When the receiver or managing controller is appointed | When the receiver's or managing controller's appointment ends |
| Voluntary administration | When the company enters into administration | When the administration ends or the company's affairs have been fully wound up (whichever occurs last) |
A number of the organisations that lodged submissions to the Committee noted that there is a stay where a company enters into liquidation as a result of voluntary administration but there is no stay where:
- a company enters into a deed of company arrangement (rather than liquidation) as a result of voluntary administration; and
- a company enters into liquidation without first being subject to administration.
The Committee considered that these types of matters "would best be clarified in regulations accompanying the legislation".
Termination on the basis of a pre-existing right
Once the stay on enforcement has ended a party can exercise the relevant contractual rights (eg to terminate for insolvency) but only on the basis of the corporation's financial position at the end of the stay period. In other words, the counterparty cannot terminate on the basis of the pre-existing contractual rights; there needs to be a fresh cause.
The Act achieves this by describing the contractual right as being "unenforceable against the body indefinitely after the end of the stay period" in certain circumstances.
There is provision for regulations to be made setting out additional circumstances where a stay may continue indefinitely.
Exceptions
The stay on enforcement will not apply to rights:
- prescribed by the regulations; or
- declared in a Ministerial determination.
The Explanatory Memorandum gives derivative contracts as an example of a type of contract that would be exempted by the regulations. The Ministerial power is intended to allow quick remedy of unintended consequences.
The restrictions also do not apply:
- to any agreements made after the commencement of a scheme, receivership or other managing controllership or voluntary administration; or
- where the relevant administrator, scheme administrator or managing controller has consented in writing to the exercise of the rights.
Commencement date
Part 2 of the Act commences on the day after the later of:
- 30 June 2018; and
- the last day of the period of 6 months beginning on the day the amending Act receives Royal Assent.
However, the Governor-General may proclaim an earlier commencement date.
As noted above, the new provisions will only apply to contracts, agreements or arrangements entered into from the commencement time of the ipso facto provisions.
For further information, please contact:
Steve McKinney, Partner, Ashurst
steve.mckinney@ashurst.com
