Ipso Facto Clauses – There’s change on the way

An important change in law arising from the raft of recent Insolvency reforms concerns enforcement of ‘ipso facto’ clauses in contracts.  As the change will impact on how you contract and do business with your customers, it is important to both understand the change and put measures in place to deal with it. 

The “Ipso whatso” clause?

Ipso facto clauses are commonly found throughout both commercial and construction contracts.  These allow a party (‘party 1’) to terminate or modify a contract on the occurrence of a trigger event, or can, for example, provide for termination of a contract when a trigger event occurs. 

Often the trigger is an ‘Insolvency Event’.  Generally what constitutes an ‘Insolvency Event’ will be broadly defined within the contract, but could be (for example) the appointment of an Administrator, a liquidator, or a Receiver or Controller to the other party (‘party 2’).  These clauses are used to provide some risk protection for a party against an insolvent client or customer.  The flip side to this is that it can create difficulty for the other party in trying to turn around its fortunes if the underlying agreement on which its business is based is terminated.

A typical example of how this clause is currently used is in a licence agreement where party 1 grants party 2 the right to use certain intellectual property in the conduct of its business.  Under the current law, an ipso facto clause might allow the licence to be terminated in the event of insolvency.

Change from 1 July 2018

Changes have been made to the Corporations Act 2001 (Cth) ^[1] which are intended to apply from 1 July 2018 and which allows for the enforcement of rights under an ipso facto clause under the following circumstances:

1.  a company enters into administration^[2];
2.  a company has a managing controller appointed over all or substantially all of the company’s property ^[3]; or
3. the company is undertaking a compromise or arrangement to avoid being wound up^[4].

The changes will apply to all new contracts, agreements and arrangements between parties entered into after 1 July 2018.

Why the Change?

The Federal Government has recognised the effects that the enforcement of these ipso facto clauses can have on a party 2 suffering from financial distress.  These effects include that it:

1. significantly impacts the financial viability of party 2’s business and general cash-flow;
2. reduces the ability of party 2 to successfully restructure and continue to trade through such restructure;
3. reduces the value of the business, if a sale of the business is being contemplated;
4. disrupts the business’ other contractual obligations, such as with its creditors; and
5. potentially reduces what creditors may be able to recover in an Insolvency administration.

So what has changed?

An ipso facto clause will be stayed (put on hold) in the three circumstances (a), (b) and (c) above.  The stay will not affect most of the other rights being enforced, such as where party 2 fails to meet a payment obligation, however if the ipso facto clause effectively goes against the reforms, then the stay may be extended to these rights.

How long is the stay?

This depends on the type of insolvency process involved. 

1. For an administration – the stay will start when the administration commences, and will continue until the administration technically ends.  However, if the administration ends with the company going into liquidation, then it will continue until the affairs of the company are fully wound up;
2. Where a managing controller is appointed over the whole, or the substantial whole of the company’s property, the stay will end when the managing controller’s control of the property ends;
3. Where the company will make, has announced it will make, or has already made an application to enter into a scheme of company arrangement under section 411 of the Corporations Act 2001, the stay will end after 3 months if a section 411 is not later made, when it is made but dismissed, when the scheme of arrangement ends – or if a resolution or order is made to wind up the company, then when the company is finally wound up.

The Court can extend any period of stay, and also has the discretion to order that these contractual rights can be enforced if it’s in the interest of justice to order this (for example, if there is a risk of insolvency of party 1).

Will there be exceptions?

There are some proposed exceptions currently awaiting consultation.^[5]  Some exceptions that have been proposed include:

1. Arrangements for the sale of a business;
2. Step-in rights in construction contracts;
3. Government licences or permits.

However, these are yet to be finalised.

So what should I be doing?

Going back to our example of an ipso facto clause in a licence entered into after 1 July 2018, party 1 would not be able to terminate on party 2 entering the restructuring process referred to in (a) (b) or (c) above.  Businesses who deal with companies should now review the terms of their agreements to ensure that there is some level of protection in the event of a default.  It would be prudent to specify just what default is being relied upon, whether as a part of a breach notice or if seeking to terminate an agreement – so that there is no confusion over the basis for the exercise of the right.

Further, in order to avoid any potential claims of repudiation of the agreement by you, it is important to seek advice prior to terminating an agreement for breach.