By Alexandra Geelan, Lawyer
On 1 July 2018, new laws came into effect that restrict certain termination rights in most commercial contracts. These restrictions provide an important opportunity for struggling businesses to restructure and turn their business around while ensuring that key contracts remain on foot. Whether you’re a growing business battling towards profitability or an established company looking to secure your long-term interests, it is important to understand how these changes may affect your business.
In short, the new laws temporarily prevent parties to a contract from exercising or enforcing their termination rights under an ipso facto clause. Unless you’re a lawyer, or lay law nerd, that last sentence probably didn’t make much sense - let us break it down for you:
What are ipso facto clauses?
Ipso facto clauses allow a party to terminate or vary a contract if the other party suffers an ‘insolvency event’ which can include:
· appointment of an administrator, liquidator, receiver or controller;
· a natural person being declared bankrupt;
· entering a scheme of arrangement with creditors;
· failure to comply with a statutory demand; and
· being unable to pay debts as and when they fall due (know as “insolvent trading”).
The definitions of “insolvency event” can be very broad and can include events that we wouldn’t assume on their face to indicate insolvency. For example, some contracts include ceasing to carry on a material part of a business as an insolvency event. For agile and fast-changing start-ups, “pivoting” is an important and necessary strategy but could be considered an insolvency event in some contracts, giving the other party the right to terminate or vary the terms of the contract.
The right to terminate under an ipso facto clause is an automatic right and arises regardless of whether the other party can and does continue to meet all of their obligations under the contract.
Ipso facto clauses are included in most commercial contracts. Termination of a contract on the basis of an ipso facto clause can further damage a company’s viability and cash flow and, if it is a business-critical contract, can be the straw that breaks the camel’s back, pushing the company into full insolvency.
What do the new laws do?
The new laws temporarily prevent a party from exercising their termination right under an ipso facto clause for a certain period of time. The new laws provide a “stay” of a contractual right to suspend or terminate that arises from:
a) a company entering administration, receivership or where a scheme of arrangement is proposed;
b) a company’s financial position if in administration, receivership or subject to a scheme of arrangement; or
c) a reason prescribed by regulation or is contrary in substance to (a) and (b).
The amount of time the termination right is stayed will depend on the type of insolvency event but starts when the event occurs, such as when the company enters administration, or a controller or receiver is appointed.
Critically, these laws do not prevent a party from terminating if the struggling party breaches the contract or fails to perform their contractual obligations as a result of the insolvency. Struggling companies must continue to ensure that they can meet their obligations under key contracts while they re-evaluate and re-structure their business.
These changes apply to contracts executed on or after 1 July 2018. This means that if your contract was entered into before 1 July 2018, or renewed or novated after this date, the new laws will not apply and the termination rights under an ipso facto clause can be enforced.
Why is this important?
A commonly held view among entrepreneurs and their supporters is that the Australian start-up scene is being held back by an unwillingness to accept failure and a lack of framework for restructuring and turning businesses around when they need it. Supporters point to the USA’s generous insolvency and bankruptcy programs as proof that we need to allow entrepreneurs and start-ups to fail in order to really experience significant and lasting breakthroughs. Protection from ipso facto clauses has long been advocated as a key stepping stone to provide a more friendly and supportive environment for innovative businesses.
The changes surrounding ipso facto laws provide businesses the time and space to re-evaluate and develop a new plan for success while ensuring that their hard-earned contracts remain in place. This much-needed security may provide companies with the confidence to make the hard decisions necessary to propel a start-up to success.
For businesses that seek to impose and rely on these terms, it is important to understand that the rights you thought you had may no longer operate the same way. If you’re getting nervous about another company’s ability to fulfil a contract that is not only critical for their business but also for yours, it is important to take the time to understand how the new laws affect when and how you can exercise your termination or variation rights.
These changes are the latest in a string of reforms aimed at creating a more supportive environment for businesses to restructure and recover, allowing them the space, time and support to take risks that may result in bigger pay-offs.
 The Treasury Laws Amendment (2017 Enterprise Incentives No. 2) Act 2017 amends the Corporations Act 2001.
At Law Squared, we partner with passionate entrepreneurs and businesses who need our technical help and expertise. We’d love to have a chat with you, so feel free to drop us an email firstname.lastname@example.org.
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