A prohibition on enforcement of ipso facto clauses will assist in restructuring companies and prevent one cause of value destruction.
Ipso facto clauses are contractual clauses which allow one party to terminate an agreement by reason only of the fact (“ipso facto”) of the insolvency of the other party. These clauses have been blamed for the destruction of enterprise value in some insolvencies, for example One.Tel.
The Government’s recent Innovation Statement includes a proposal to make ipso facto clauses unenforceable if a company is undertaking a restructure. This announcement reflects the strong sentiment for policy reform to promote a restructuring culture and encourage businesses to seek professional guidance before succumbing to higher levels of financial distress. It is widely recognised that Australia’s existing insolvency regime is overly legalistic in some respects, with a strong bias towards preserving creditors’ rights.
Under the existing corporate insolvency and voluntary administration regime in Australia, there is no prohibition or moratorium on enforcement of ipso facto clauses. These clauses are found in many critical supplier contracts, franchise and licence agreements and leases for land and equipment. Where such clauses exist, the appointment of an administrator to a financially distressed company can result in the company’s main trading partners invoking their right to automatically terminate the contracts, even though all payments are up to date and there is no other breach of the contract. The result? There is no business to restructure, the value of the company’s goodwill plummets and there is no longer any going concern for creditors.
The primary policy objectives behind Part 5.3A and s 435A of the Corporations Act are, in principle, to facilitate and maximise the chances of a business continuing to exist, despite financial distress. However, where ipso facto clauses are present in valuable contracts, these primary policy objectives may not be achieved as the business operations of the company can be prematurely extinguished, despite evidence that the business is capable of carrying on. For this reason, many insolvency practitioners, lawyers and industry representative bodies have for some time called for a complete prohibition on enforcement of ipso facto clauses in Australia.
In its report “Business Set, Transfer and Closure” published in December 2015, the Productivity Commission noted that the operation of these clauses severely reduce the scope for a successful restructure of a business and recommended amendments to the Corporations Act.
There is of course a risk that the suspension of ipso facto clauses will be ineffective in the long term as creative drafting by lawyers will lead to contractual terms essentially circumventing the prohibition. Additionally, it remains to be seen how involved the court processes will be. Critics of the US framework point to the convoluted (and expensive) procedure associated with the Chapter 11 framework and there could be a risk that these insolvency reforms may go down a similar path and promote litigation.
The Turnbull Government announced the decision to make ipso facto clauses unenforceable if a company is undertaking a restructure. This reform is one of the spokes in the Turnbull Government’s policy wheel to revamp Australia’s insolvency laws and encourage entrepreneurship. There is strong merit to the argument that changes need to be made to Australia’s insolvency laws to support the rehabilitation of viable businesses and preserve their value. A prohibition on enforcement of ipso facto clauses is a step in the right direction. As always, the devil will be in the detail.
The US’s Chapter 11 regime has as a key component the prohibition on the enforcement of such clauses. Of course, Chapter 11 regime is culturally unique to the US and Chapter 11 in its entirety would be an awkward fit given Australia’s differing approach to corporate culture and values (square pegs in round holes comes to mind). Nonetheless, the value-preserving features of prohibiting or suspending ipso facto clauses could readily be “borrowed” from the Chapter 11 regime and implemented in Australia.