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Client Update: Construction contracts and the new 'ipso facto' insolvency reforms

1 June 2018

In brief: New insolvency legislation that is designed to provide greater opportunities to restructure failing businesses, both before and during external administration, has recently been passed. The reforms restrict the enforcement of contractual rights triggered by voluntary administration, receivership or schemes of arrangement to avoid being wound up in insolvency (known as 'ipso facto' clauses). These changes will have significant ramifications for those involved in the construction sector. Partner Leighton O'Brien (view CV) and Lawyer Daniel Abadee report.

Background

Like many contracts, construction contracts ordinarily permit a principal to exercise certain contractual rights where a contractor becomes insolvent or suffers some other 'insolvency event'. Upon the insolvency of a contractor, these so-called ipso facto rights typically permit a principal to:

  • terminate the contract;
  • suspend the works or take the works out of the contractor's hands; or
  • call upon a bank guarantee, cash retention or other security.

These rights arise regardless of whether or not the contractor remains able and willing to perform its obligations under the contract in the immediate term, and are designed to provide quick recourse to a principal where a contractor's financial position renders it doubtful that the contractor will be able to fulfil its obligations under the contract in the longer term. Delay or interruption to a project is minimised, as the principal is not required to wait until an actual breach by the contractor, or an administrator's determination as to whether the contractor will be able to continue performing the contract, prior to exercising an ipso facto right.

The policy behind the legislation is that enforcement of ipso facto rights against a contractor or other party on the appointment of an insolvency administrator often erodes or destroys the value of its business and undermines the potential for it to be successfully restructured.

What the reforms do

The reforms, which take effect from 1 July 2018, stay or restrict the enforcement of certain ipso facto rights under a contract, regardless of whether such rights purport to arise automatically or at the discretion of any party to the contract. The stay on enforcement is triggered if a right arises under a contract because:

  • an administrator is appointed;
  • a managing controller (usually a receiver) is appointed over the whole, or substantially the whole, of a company's assets; or
  • certain steps are taken to propose a scheme of arrangement to avoid winding up (in the case of a listed public company, this includes announcing such a scheme).

In such scenarios, a contractual right is also unable to be enforced where that right is triggered by a company's financial position during the period that it is under administration or receivership, or subject to a scheme to avoid being wound up. A principal nevertheless remains able to exercise its contractual rights (including termination) on the basis of another default. Eg a principal may still terminate a contract on the basis of non-payment or non-performance by a contractor even where the underlying reason is insolvency.

The reforms only affect rights arising under contracts entered into after 1 July 2018. This means that the changes do not affect rights arising under:

  • contracts that were entered into before 1 July 2018; or
  • amendments to contracts, where the original contract was entered into before 1 July 2018.

Despite the stay on enforcement of an ipso facto right, a party will be permitted to enforce such a clause if the contractor obtains the written consent of the administrator, receiver or scheme administrator, or an order of the court permitting the enforcement of such right.

Exceptions to the stay

The Federal Government released for public consultation draft exceptions to the stay. Most relevant to construction contracts are proposed exceptions relating to step-in and set-off rights under contracts.

Step-in exception

Under the draft exceptions, the right to perform contractual obligations of an insolvent contractor are excluded from the stay. The explanatory statement to the draft exceptions specifically references step-in clauses in construction contracts as rights that should not be disturbed by the reforms.

Set-off exception

There is an exclusion for rights to set-off or to net balances under a contract. The explanatory statement explains that there would be no benefit in applying the ipso facto stay to such rights, as these arrangements have the effect of simplifying a transaction and reducing the amounts that need to be exchanged to settle it. In addition, the draft exceptions prescribe that the ipso facto stay does not apply to a contract insofar as it contains acceleration rights that are necessary to take the full benefit of the protected rights of set-off or net balancing.

Impact on the construction industry

The reforms will have a significant effect on construction contracts. A principal will be unable to rely on a contractor experiencing certain types of insolvency-related events to enforce clauses that give rise to a right to terminate or to call upon security.

The reforms will advantage contractors, who will retain the benefit of existing contracts despite eg entering into voluntary administration with the goal of trading out of insolvency. However, contractors should be mindful that managing subcontractor insolvency risk will become more difficult. They will no longer be able to rely on rights to terminate a subcontracting arrangement where a subcontractor suffers certain insolvency events. Provisions in head contracts that restrict the provision of relief to a head-contractor to after the termination of an arrangement with an insolvent subcontractor should be reconsidered. Head-contractors may also resist taking on the risk of subcontractor insolvency in all cases.

Principals and head-contractors should be mindful not to seek to enforce an ipso facto right in breach of the new legislation. Where a principal or head-contractor purports to do so, the contractor could itself seek to terminate the contract and seek damages on the basis that the principal has invalidly repudiated the contract (given it had no right terminate) or breached the contract by having ceased performance of its obligations (despite the contract still being on foot). Principals and head-contractors should also review self-executing provisions that purport to trigger impugned ipso facto rights automatically.

Further considerations

Principals and head-contractors should consider the drafting in contracts entered into after 1 July 2018, and be aware that they will be unable to rely on certain rights that are purported to be exercisable (or automatically occurring) upon contractors or subcontractors appointing an administrator or a receiver, or proposing or entering into a scheme of arrangement to avoid winding up. While parties are unable to contract out of the ipso facto reforms, principals and head-contractors may consider events of default or performance requirements in contractual arrangements to minimise exposure to contractor insolvency risk.

For further information, please contact:

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