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Uncertainty of contract – the ‘safe harbour’ and corporate insolvency amendments

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30 May 2018

Over a nine month period to July 2018, amendments to the Corporations Act come into force which significantly limit the ability of corporate parties to rely on an ‘insolvency event’ to modify or terminate their contracts entered into after that date.

Touted as a long overdue softening of Australia’s company insolvency laws, the two-stage amendments aim to give company directors a legally defensible way to turn their businesses around (including incurring more debt) without the risk of being in breach of the prohibition on trading whilst insolvent. The downside is yet another diminution in the predictability that legal rules are intended to bring to commerce and economic activity generally.

The first component of the new laws is known as the ‘safe harbour’ protections. Their effect is to say that a director’s personal liability for debts incurred by an insolvent company is suspended in certain circumstances. Those circumstances involve the director developing a course of action that is ‘reasonably likely’ to lead to a turnaround in the company’s fortunes. Any debt incurred during the implementation of the turnaround does not incur personal liability for the director.

Perhaps curiously the threshold for indications of a turnaround in progress is that the company files its tax returns on time and likewise pays its employee entitlements. Whilst these public interest objective are admirable, a cynic may say that the ‘safe harbour’ provisions are no more than an attempt to enable the government and a portion of its constituency to get out unscathed before the inevitable happens

 The second stage of the new anti-insolvency laws is informally known as the ‘ipso facto’ clause amendments. This phrase is lawyers’ shorthand borrowed from Latin, and means ‘by the mere fact’.

It is a label applied to a clause that is ‘self-executing’. In other words, the relevant clause deems a party to be automatically in default simply by a defined event happening to, or affecting that party.

For example, in company loan contracts, it is common to see wording like the following:

Right to Terminate

The lender may terminate this contract if any of the following events occurs:

(Insolvency) the borrower enters into, or any steps are taken to have the borrower enter into liquidation, provisional liquidation, receivership, receivership and management, administration, bankruptcy or any arrangement, reconstruction or composition with the borrower’s creditors, or a controller is appointed with respect to any of the borrower’s assets or the borrower fails to pay its debts as they fall due or the borrower otherwise becomes insolvent.

This insolvency event of default creates an automatic right for the lender to terminate its contract, but from 1st July 2018 that immediate right to take remedial action will no longer be available. The new ipso facto laws act in concert with the preceding ‘safe harbour’ amendments to impose a ‘stay’ or delay on the enforcement rights of the solvent party. The intention is that the insolvent party may have an opportunity to trade out of its difficulties

To continue with the finance example, a credit provider’s traditional right to protect its investment in the event of the serious breach or default by the customer have now in theory been limited. Even non-financial parties may be obliged to continue supplying their goods or services on credit as a result of the amendments. Only in the case of the customer’s liquidation would the non-insolvent party be protected from the application of the new laws, but by then it’s often too late to mitigate against loss.

For these kinds of reasons, the federal Treasury recently released draft clarificatory material comprising a ‘Regulation’ and a ‘Declaration’. The latter lists ‘arrangements’ (transactions) which are to be excluded from the stay on enforcement of the ipso facto amendments. The excluded transactions effectively comprise a laundry list of financing arrangements, plus a significant number of rights of enforcement or protective rights typically found in commercial contracts.

Examples of the excluded finance arrangements are the Cape Town Convention on International Interests in Mobile Equipment (jet aeroplanes and their engines), international commercial ship charters, government licences and permits, securities underwriting and issuance, business and share sale agreements, factoring, margin lending, and so on.

Examples of the commercial rights excluded from being stayed are rights to demand indemnities and payment of expenses, default interest calculations, step-in rights, certain receiver appointments, and rights of assignment and novation.

In brief, the proposed exclusions from the impact of the ipso facto amendments are numerous and wide-ranging, from the very general to the quite specific and technical in nature. There is also significant ambiguity in relation to their scope. For example, under the definition of ‘financing arrangement’ in the Declaration’s Interpretation paragraph 4(b), finance leases and hire purchase are specifically mentioned, but not so operating leases or rental agreements. All within the same finance product family, yet the latter two must look for exclusion from ipso facto to the uncertain catch-all in the preceding paragraph 4(a) of ‘financial accommodation’.

The number of financial and other exclusions from the anti-insolvency amendments to the Corporations Act create doubt about what is in fact being achieved The sentiments may be noble – to assist companies to exit a financial distress scenario in a positive way, rather than be carved up and economic benefit lost. But the extent of the exclusions mean that contract drafters will now have to refer to government regulation to determine which commercial dealings are affected and which are not.

It is not just certainty of contract that is being eroded but freedom of contract as well.