When a business starts to fail – the new law affecting companies, suppliers and advisors!


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When a business starts to fail – the new law affecting companies, suppliers and advisors!

A long overdue reform on the operation of IPSO Facto Clauses to increase the chances of companies facing difficulty to either return to successful future operations or to improve returns for all involved in the event of an insolvency event!

Running a business is hard at the best of times, what with keeping customers happy and staff and suppliers paid. Keeping a business running when it enters a dangerous financial stage – insolvency – is harder still!  Skilled administrators are often needed to assess the business and try to keep it going and maintain its goodwill. This is often for two purposes – either to turn the fortunes of the business around and restore its profitability, or if that is not possible, to sell the business for a reasonable price as a ‘going-concern’.

What often occurs in that precarious insolvency scenario is that suppliers opt out of their supply contracts, either because they are fearful they won’t be paid, or because they want to get out of the contract anyway.  Up until now, they could rely on what are called ‘ipso facto’ clauses found in most contracts – meaning the contact can be ended ‘for the reason only’ that the company enters insolvency.

What is it?

In the insolvency context, an ipso facto clause is a clause in a contract that allows one party to terminate or modify the operation of the contract upon if the other party enters insolvency, for example, liquidation or voluntary administration. These clauses are used to provide some risk protection for a party against an insolvent customer.  The flip side to this is that it can create difficulty for that customer in trying to turn around its fortunes, if the underlying agreement on which its business is based is terminated.  This can result in irreparable damage to the value of a business which may require key contracts to continue to operate, and can also undermine the ability to restructure, turn around or sell (as a going concern) a business within a formal insolvency process.

Despite the efforts of a voluntary administrator, there may be not much left at all resulting in creditors getting nothing and what might have been a potentially successful line of new business, is lost to the economy.

New Law Reform:

Law reforms that commenced on 1 July 2018 now assist administrators in these scenarios. If directors act early enough to call in a voluntary administrator to their company, the law prevents suppliers from relying on ipso facto clauses to end their supply contracts.  Of course, the suppliers must continue to be paid, through the administrator, and it can often be in their interests to do so.  The company’s business might be restored by the administrator, or sold to another operator, and suppliers retaining that client, despite its difficulties, may prove to be worthwhile in the longer term.

Who does it affect?

The changes are relevant to any company going through voluntary administration, scheme of arrangement, deed of company arrangement or receivership, that is dependent on contractual agreements for its livelihood, and where those contracts have ipso facto clauses.  These clauses are often found in contracts of service-based businesses whose values are based more on their various contracts than on their physical assets.

The changes apply to all new contracts, agreements and arrangements between parties entered into after 1 July 2018, so the law is not retrospective. This is one serious impediment for an administrator and at the same time a bonus for those who have such clauses in their pre-existing and on-going contracts.

The triggers for the new law:

The protection for a struggling business extends beyond the appointment of an insolvency administrator. Ipso rights are now unenforceable against the counterparty if they arise for the reason of:

  • a change in the credit rating of the counterparty;
  • 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 counterparty’s financial position; or
  • subject to court order, termination for convenience based on the counterparty’s financial position.

Otherwise, the stay against enforcing rights of termination will not affect most of the other rights being enforced, in particular, those based upon a failure to meet payment obligations, provided that they are not prevented in some other way under the particular terms of the new law.

Exceptions:

There are many and legitimate exceptions to the stay being imposed; for example, a lender does not have to continue providing a loan facility. Other exceptions are focused on particular industries such as certain maritime contracts and defence and security related services. Others are more broad-ranging and include:

  • Arrangements for the sale of a business;
  • Supply of goods or services relating to hospitals or public health services; and
  • Government licences or permits.

The suppliers’ perspective:

As for the suppliers, their position is protected because the administrator must have funds to be able to continue to pay the supplier, otherwise, the supplier may still terminate the contract for non-payment.  Involuntary administration, suppliers also have some protection in the form of the statutory personal liability of the administrators.

At a practical level, it should be noted that there are cases where a supplier does not wish to rely on its ipso facto rights, upon an assurance from the administrator that the supplier will continue to be paid; and there are also those cases where the administrator decides that the supplies are not in fact necessary for the business and accepts the ending of the supply contract.

Summary:

This reform is long overdue for companies that are genuinely needing to go through a restructuring process which may trigger an ipso facto clause.  At the same time, the law tries to balance that with the rights of suppliers, whose on-going rights to payment are preserved. Given the limits and exception to the new law, it is important for both parties to a contract to understand the new law so as to avoid unnecessary disputes.

From an administrator’s (and the company’s) perspective, the ability to continue contracts, properly monitored, will likely result in improved returns for creditors and improved likelihood of success in the future operations of the business. At the very least, it should allow the administrator some breathing space to be able to assess the viability of any contract and determine whether it is in the best interests of all parties to continue with it.  Indeed, there may even be a heightened perception that the administrator has more of a position of authority in regard to the contracts now that the legislation has come into force, and that may affect the outcome of negotiations.

Either way, the impact of the legislation will be dependent on the ability of each party to successfully and commercially negotiate the arrangements under the contract.

If you or someone you know would like assistance in relation to any of the above, please call dVT Group on 02 9633 3333 or email mail@dvtgroup.com.au.