Insolvency and ipso facto termination of contracts

Reforms to insolvency laws which commenced on 1 July 2018 prevent contracting parties from relying on what are commonly referred to as ipso facto termination clauses in commercial contracts.

The ipso facto reforms aim to give companies facing financial difficulties an opportunity to trade their way out of their predicament rather than having a contract unilaterally terminated. A contracting party will no longer be able to rely on an ipso facto clause to end a contract in certain circumstances pertaining to the other party’s financial position.

Businesses should be aware of the impact of these changes and review their contracts and internal processes accordingly.

What is an ipso facto clause?

The words ipso facto are Latin and mean ‘by that very fact or act’.

An ipso facto clause allows a party to terminate the contract based on the existence of a fact or circumstance, rather than a default by the other party. In commercial contracts, a trigger for invoking an ipso facto clause will generally include an insolvency event, whether actual insolvency or a precursor to insolvency, such as the appointment of an administrator.

The benefit to a party invoking an ipso facto clause is the potential to mitigate loss by taking action once the risk of insolvency becomes apparent.

How do the reforms change ipso facto clauses?

A party to a contract is now restricted from relying on an express ipso facto provision in the contract to terminate the contract by reason of:

  • the other party entering a scheme of arrangement or voluntary administration;
  • the other party’s financial position, credit rating or the possibility that it might be under administration.

Effectively, the reforms put a ‘stay’ on a party exercising certain rights on the basis of a potential or pending insolvency to allow the other party to continue receiving the benefit of the contract, in the hope that it can trade its way out of financial difficulty.

The reforms do not affect other termination rights under a contract (such as termination for non-performance) or statutory rights. However, a party wishing to rely on such clauses should be able to demonstrate the legitimacy of its right to terminate by reason other than the other party’s financial position.

How long does the stay apply for?

The nature of the insolvency event and the relevant circumstances will determine the length of the stay. The stay will be lifted once the insolvency event ends or on the expiration of Court orders granting an extension of the stay.

If the contracting company subsequently goes into receivership or liquidation, the stay is lifted, the protection no longer exists, and the ipso facto rights will be enforceable.

In other circumstances, the stay may be lifted – either by arrangement between the administrator and the party seeking to rely on the ipso facto clause, or on application by that party to the Federal Court, if it would be appropriate and in the interests of justice to do so.

The new laws are mandatory and cannot be contracted out of, with special government intervention powers being granted to address any loopholes.

The laws are not retrospective, thus any ipso facto provisions existing in contracts entered before 1 July 2018 remain unaffected.

What should company directors do?

Managing financial risk in commercial contracts has always formed an integral part of sound business management. The ipso facto laws highlight, the importance of directors to implement proactive risk-management processes.

Company officers should understand the potential effect of the ipso facto regime on contracts. We recommend directors:

  • review contracts to consider how termination rights will be affected during an insolvency event;
  • conduct sound due diligence before contracting with other parties including company and name searches, Personal Property Securities Register checks and inspections of financial records;
  • obtain director guarantees and / or parent company guarantees;
  • strengthen other provisions of standard contracts to preserve termination rights, increase security and / or performance requirements; and
  • obtain legal advice immediately upon becoming aware of a contracting party’s insolvency issues to ensure termination rights are properly managed.

If you or someone you know would like more information or advice, please contact us.

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