Out-Law Analysis | 31 Jul 2018 | 9:48 am | 5 min. read
Most construction contracts contain a right to terminate or take other action upon the occurrence of an insolvency event and the new ipso facto regime places a stay on those rights unless an exception applies. The consequences of non-compliance are significant, potentially exposing those exercising contractual rights against their insolvent counterparties to repudiation and wrongful termination claims.
Caution is required when exercising contractual rights against counterparties upon the occurrence of an insolvency event as a consequence of recent reforms in this area. It is important that those operating in the infrastructure sector understand the impact that the legislative changes will have on their contractual arrangements, and take appropriate action.
Standard form contracts should be revised to both protect against inadvertent termination contrary to the ipso facto regime as well as to incorporate other protections, such as step-in rights, to assist with the management of insolvency risks.
The ipso facto regime
The recent 'ipso facto' legislative reforms, effective 1 July 2018, affect the ability of a party to exercise contractual rights to terminate, and other contractual rights, where those rights arise because of a counterparty's insolvency. The reforms are outlined in the Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 (Cth) (Amending Act), which amended the Corporations Act 2001 (Cth).
Many contracts include 'ipso facto' insolvency clauses: clauses which allow one party to exercise certain rights where a counterparty suffers from an insolvency event. In an infrastructure context, such rights might include the right to:
The ipso facto legislative reforms impose a stay on the ability of a party to exercise these contractual rights, where the contractual rights arise because of:
The ipso facto legislative reforms also contain anti-avoidance measures, which stay the ability of a party to exercise rights where the reason for exercising those rights is contrary to the legislative reforms in substance. Unless an exception applies, a principal will not be able to enforce a right to, for example, terminate the contract or call upon security because of a contractor experiencing an insolvency-related event.
Rights and contracts excluded from the stay
Certain types of contracts and rights are excluded from the ipso facto stay. Most relevantly in the infrastructure context, these include:
Effectively managing subcontractor insolvency risk
Termination for insolvency clauses
The consequences of non-compliance with the Amending Act can be significant. Termination of a contract in breach Amending Act could be classed as repudiatory conduct and place the terminating party at risk of a claim for wrongful termination and claims for loss of profit.
Given the serious consequences of failing to comply, we recommend amending 'termination for insolvency' clauses so that any right to terminate is expressed to be subject to the ipso facto legislative provisions. Drafting 'termination for insolvency' clauses in such a way minimises the risk of wrongfully terminating, as contract administrators will be prompted to query their ability to terminate in this context.
Calling on security
The anti-avoidance provisions contained in the ipso facto legislative regime intend to capture conduct that attempts to circumvent the new legislation. Accordingly, it is recommended that caution be exercised if calling on security – even in the case of an unconditional bank guarantee – as there is a risk of falling foul of the anti-avoidance provisions. It is also recommended that security arrangements be reviewed to determine whether additional performance security is required, such as a parent company guarantee, to assist with ensuring performance of contractual obligations.
Termination for convenience
Although termination for convenience is permitted under the legislation, contractors should exercise this right with caution to ensure that they are not acting contrary to the Amending Act. In theory, if the right is exercised for convenience and not because of the other party’s financial position or the restructuring process, the stay should not apply. In practice, however, it may be difficult to establish that the reason for the termination was not connected with the insolvency event.
Events of default and show cause regimes
The ipso facto legislative reforms will not prevent parties from enforcing their contractual rights to terminate the contract, or take other action, for unrelated reasons, such as for non-performance or for convenience. Review of contractual events of default is recommended to ensure that the show cause regime attaches to a broad range of events of contractual non-performance, including things that may be an indicator or warning that a subcontractor may be facing financial hardship. Such indicators might include:
Since step-in rights, and the related right to engage others to perform the work, are excluded from the operation of the ipso facto stay, we recommend that contracts include step-in rights to be exercised in the event of a counterparty's insolvency. To date, step-in rights have most commonly been included in contracts for PPP projects; however, we expect that their exclusion from the ipso facto regime will mean that we start to see them in a much broader range of contracts.
On a related note, principals should consider including clauses in subcontracts which enable them to recover the costs associated with preserving and enforcing step-in rights, and other costs like lenders' interest and charges incurred due to insolvency. Additionally, it may be worth ensuring such costs are:
Revise procurement processes
We recommend review of existing processes in relation to pre-qualification of subcontractors to ensure that the level of financial due diligence of subcontractors and their related entities is adequate. Such review should ensure that previously 'approved' subcontractors, new subcontractors, and their related entities are: