Ipso Facto Rights
When a party to a contract experiences an insolvency event or encounters financial difficulty, there are likely to be certain rights that arise under a contract which are generally known as ‘ipso facto’rights. Ipso facto clauses in contracts allow a party to the contract to exercise rights, such as terminating or modifying the contract, even if the insolvent party to the contract is still able to continue to perform its obligations under the contract.
Prior to the recent amendments to the Corporations Act 2001 (Cth) (Corporations Act), when a party to a contract became insolvent, the other party to the contract could typically exercise one (1) or more of the following ipso facto rights under a contract to improve or protect their position:
- Suspend the works or take the works out of the insolvent party’s hands.
- Terminate the contract on the ground of the other party’s insolvency.
- Call upon a bank guarantee, cash retention or other security to reduce their loss.
- Step-in and pay or engage essential subcontractors directly to mitigate loss and complete the outstanding works.
Such rights have been criticised for reducing the scope for the insolvent company to successfully restructure, to prevent the sale of businesses as a going concern and because they reduced and eliminated returns in liquidation due to the destruction of value held in the insolvent company’s contractual arrangements.
For example, if a company with a strong asset base had short term lack of liquidity which led to the directors of the company appointing a voluntary administrator, an ipso facto clause in a contract would have allowed a major supplier or customer of the company to cancel their contract, in turn depriving the business of the chance to continue trading.
Reform and Amendments to the Corporations Act
As of 1 July 2018, restrictions on ipso facto rights will be included in the Corporations Actunder Parts 5.1 (arrangement with creditors/reconstructions), Part 5.2 (receivers and other controllers) and Part 5.3A (administration).
The amendments intend to restrict a party from exercising their contractual and termination rights solely as a consequence of a company entering into administration or receivership.
This reform is aimed at enabling businesses to continue to trade and maintain their existing valuable contractual arrangements in order to recover and restructure from an insolvency event.
In summary, the ipso facto rights in a contract will be unenforceable against the insolvent party (only if the contract is entered into on or after 1 July 2018) if they arise for the reason of:
- the administration, receivership or proposed scheme of arrangement;
- the credit rating of the insolvent party;
- a breach of financial covenants such as net tangible assets or debt to equity ratios;
- a change of control or material adverse effect based on the insolvent party’s financial position; or
- subject to court order, termination for convenience based on the insolvent party’s financial position.
If you require assistance in respect to your contractual arrangements and commercial related matters, contact our Business Law Accredited Specialists, Justin Thornton at email@example.com or Rahul Lachman at firstname.lastname@example.org or on (02) 4626 5077.
The contents of this publication are for reference purposes only. This publication does not constitute legal advice and should not be relied upon as legal advice. Specific legal advice should always be sought separately before taking any action based on this publication.