Ipso Facto Reform: ‘A breath of fresh air’ for distressed Companies; and a major change to Contract Law. Are you prepared?

Ipso facto provisions are a common staple found in almost every commercial Contract one can think of but, starting from 1 July 2018, there will be new laws which restrict a party’s right to enforce an ipso facto clause. The legislative reform to the Corporations Act 2001 (the Act) is great news for struggling companies but – questions on the intervention to freedom to contract aside – what will the changes mean for counter-signing parties?

What is an ipso facto clause?

Ipso facto translates to ‘by that very fact or act’. An ipso facto clause is one which allows an insolvency event (that ‘very fact or act’) to automatically trigger the right for a party to terminate a Contract (regardless of whether contractual provisions have been breached at that time).

An insolvency event is often broadly defined to include phases prior to the winding up of a Company including insolvency, the appointment of a managing controller and the Company entering formal administration.

The reason why an ipso facto clause exists is so that a party has the contractual right to exit a Contract as soon as liquidation of the other party becomes a risk; rather than be obliged to wait for it to occur and then, potentially, suffer distress itself as a consequence.

While ipso facto clauses make sense to a party which may balk at a prospect of its contractual counter-signing party possibly being on the verge of liquidation, they often have a devastating effect on companies which could, otherwise, have a genuine prospect of restructuring and successfully trading out of trouble; which is not even a remote possibility once suppliers and others run an ipso facto mile.

What happens to ipso facto clauses after 1 July 2018?

It is important to note that ipso facto clauses in Contracts entered into prior to 1 July 2018 will still be capable of enforcement and that the new laws will only apply to Contracts entered into after 1 July 2018. Will parties be able to simply amend or vary existing contracts rather than enter into new ones in an attempt to get around the new laws? This remains to be determined and there are other unknowns which the Courts are likely to clarify in due course. Interesting litigation is anticipated.

Meanwhile, what we do know for certain, is that the reforms will mean that there will be an automatic stay on enforcing ipso facto clauses in the event the distressed party to the Contract becomes insolvent, has a managing controller appointed or goes into administration. Parties which attempt to enforce ipso facto clauses (without seeking special leave from the Federal Court, for example, in instances in which lifting the stay would be appropriate in the interest of justice; or in some limited exceptions) could expose themselves to staggering damages.

If in doubt it will be critically important for parties to speak with their legal advisors prior to taking any adverse action against the distressed party (including the suspension of works, calling in of bank guarantees and other contractual measures outlined in ipso facto provisions).

Ipso facto rights will still be enforceable when the distressed company falls into receivership or liquidation.

What should you do?

Due diligence in counter-party selection will be increasingly important; as will fully understanding the provisions in one’s Contract and how they interact with the new legislation.

Clauses which require a counter-signing party to update on their financial status could also be useful combined with termination for convenience clauses (however, see your lawyer as termination for convenience clauses may not always be enforceable depending on how they are drafted).

Contractual rights which are not affected by the legislative changes should be strengthened with extra protective measures in place.

And, as always, have a conversation with your lawyer.

Written by
NB Lawyers