Like us, you may at first have read straight past the headlines of recent articles about the “ipso facto” changes in the context of the safe harbour reforms. However, on further exploration it’s clear that it will be important for businesses and their commercial advisers to be aware of this upcoming legislative change.
The ipso facto changes and safe harbour changes, both relating to insolvency, are both included in the recent package of enterprise incentive reforms as part of the National Innovation and Science Agenda.
Directors have long been subject to strict requirements preventing them from allowing a company to trade when insolvent, meaning that companies in financial distress had to promptly appoint an administrator or liquidator.
The safe harbour reforms under the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 will protect directors from personal liability, but allow the company to continue to trade and incur debts, where the directors start developing a course or courses of action that are reasonably likely to lead to a better outcome for the company than immediate administration or liquidation. The company will need to meet employee entitlement, tax and other statutory requirements.
The goal of these reforms is, in part, to attract investment, and experienced directors, to new businesses in the start-up economy, and to allow businesses to trade out of early difficulties.
Rights triggered by insolvency (“ipso facto” rights)
As part of the package of enterprise incentive reforms, the new “ipso facto” regime will commence on 1 July 2018.
Ipso facto rights are rights under a contract that allow Party A to take action on the occurrence of a specified event; they can be distinguished from rights that arise on Party B’s breach.
In this context, we are talking about Party A’s rights to take action when Party B becomes insolvent. Common rights include:
- suspending or stepping in;
- calling on a bank guarantee or other security;
- setting-off; or
- cancelling or changing credit terms.
In the past these have been seen as sensible rights for Party A to have in case of Party B’s insolvency. For customers, they allow an orderly transition to a new supplier before the supplier stops performing altogether. On the other side, they allow suppliers to minimise their losses when a customer looks likely to collapse owing funds.
Under the enterprise incentive reforms, as Party A you will not be able to exercise ipso facto rights arising from your Party B’s:
- voluntary administration;
- a scheme of arrangement; or
- financial position, where it is subject to one of the reasons above.
The legislation includes anti-avoidance provisions which cover reasons that, in substance, are contrary to the new rules. Likely areas to be caught here are a breach of financial covenants, like debt to equity ratios or net tangible assets. In some circumstances Party B may be able to prevent you from exercising other rights, such as a termination for convenience right, that you have chosen to exercise solely because of Party B’s financial position.
You will still be able to exercise rights for an actual payment default or breach of obligations to perform.
Your rights are stayed during the period of the insolvency process, but cannot be reactivated in respect of the original issue once the stay period is over.
There are exceptions where your Party B is a foreign entity which becomes insolvent, or your contract is governed by overseas law. Some additional exceptions will also be prescribed by regulation – these are likely to be banking and financial markets contracts.
What should you do?
The reforms are not retrospective. If your contract is in place before 1 July 2018 and continues to run into the future, your contract will be grandfathered and you will still be entitled to exercise rights triggered by insolvency.
For contracts which are made after 1 July – including contracts which expire and are then renegotiated after 1 July – you will need to review your processes in 2 key areas:
- avoid the risk of accidentally exercising these rights, if they have been included in the contract, without your Party B’s agreement. Although there are no legislative penalties, you will run the risk of breaching the contract yourself (potentially a repudiation entitling your Party B to make a claim against you) if you try to terminate for insolvency when you are not entitled to do so.
- review your credit terms and how you will react to early warning signs of insolvency in the future. It may be too late to wait to act until there has been an actual contract breach, so suppliers may react to these changes by allowing shorter credit terms overall, and customers may need to place more focus on developing back up options for when a supplier collapses.
If termination and step-in rights for insolvency are important to your business, you should also consider:
- taking steps to keep current contracts on foot, rather than allowing them to expire and then renegotiating, and
- whether, under your contract, each new order is treated as a separate contract or as part of the original, grandfathered contract.
Thanks to Scott Mannix at Maddocks for an excellent recent presentation on this important issue.