It is common for contracts to include a right for a party to terminate (an ‘ipso facto’ termination right) where the other party suffers an ‘insolvency event’. On 1 July 2018, amendments to the Corporations Act 2001 (Cth) will come into force which significantly curtail the exercise of that right. These amendments have significant implications for principals and contractors alike and will need to be factored into their assessment and management of counterparty credit risk.
What is an ‘ipso facto’ termination right?
In the insolvency context, an ipso facto termination right is a contractual right to terminate a contract where the other party suffers an insolvency event (which is usually broadly defined in the contract), notwithstanding that the counterparty is otherwise in full compliance with the contract.
Rationale for the amendments
Ipso facto termination clauses have historically been drafted on very broad terms such that:
- one party has been able to terminate where the other suffers a ‘hair trigger’ insolvency event; and
- financially stressed, but potentially viable, counterparties have often been pushed into ‘true’ insolvency via the exercise of these rights and without having been given a reasonable chance to trade out of their difficulties.
In this context, the Commonwealth Government’s rationale for its amendments is that it is in the public interest for financially stressed parties to be given a reasonable opportunity to resolve their financial issues before ipso facto termination rights can be exercised.
What will change on 1 July 2018?
The main change that will occur when these amendments take effect is that, regardless of the terms of a contract, it will no longer be possible to immediately terminate it where that right is triggered by the counterparty:
- coming under administration pursuant to Part 5.3A of the Corporations Act;
- undertaking (or announcing) a compromise or arrangement under Part 5.1 of the Corporations Act which is aimed at avoiding being wound up in insolvency; or
- having a managing controller appointed over all or substantially all of the property of the company under Part 5.2 of the Corporations Act.
Instead, a stay on the enforcement of the ipso facto termination right will apply for a period defined in the Corporations Act.
Some rights unaffected
Two broad categories of ipso facto termination rights are unaffected by the amendments:
- ipso facto termination rights included in contracts executed prior to 1 July 2018; and
- ipso facto termination rights triggered by a party undertaking an informal restructure (outside of Part 5.1, 5.2 or 5.3 of the Corporations Act).
Protecting your interests
The inclusion of a broad definition of ‘insolvency event’ coupled with a broadly drafted ipso facto termination clause has often been viewed as an efficient cure to many counterparty ills. Unfortunately, this will no longer be the case in respect of contracts executed on or after 1 July 2018 and a more considered approach will need to be taken to mitigating counterparty credit risk, which may include:
- strengthening your right to terminate for a failure to pay;
- strengthening your right to terminate for convenience;
- requiring additional security; and/or
- exercising options to extend existing contracts to preserve your ipso facto termination rights given that the amendments do not apply retrospectively.
Authored by Joel Sturgeon, Partner, Newcastle.