Terminating the Right to Terminate?: Ipso Facto Clauses in Contracts
Commercial lawyers, and their clients, are familiar with ipso facto clauses.
The effect of an ipso facto clause is that “if event X happens, consequence Y follows.” Examples include:
- In a contract for the sale of land, if a party dies the counterparty has a right to terminate;
- In a services agreement, if payment is made late the counterparty has a right to suspend the services; and
- In a building contract, in certain circumstances the builder may call upon a bank guarantee.
However, the most common example of an ipso facto clause – and the usual circumstance where the term is used – is when a contract dictates that when an “insolvency event” occurs, the counterparty has an instant right to terminate.
This allows one party to get out of a contract as soon as the risk of the other party becoming insolvent arises.
Typically an insolvency event for a company will include:
- The company entering into a deed of company arrangement;
- A controller or administrator being appointed to the company;
- An application being made to the court for the company to be wound up;
- The court making an order that the company be wound up;
- The company passing a resolution that it be wound up voluntarily; and
- A mortgagee of some of the company’s property taking possession of that property.
The power of an ipso facto clause is that even though there has been no breach of the contract, the mere happening of an event (over which the parties may have no control and which may be irrelevant to the parties’ ability to otherwise perform their obligations) allows one party to terminate the contract.
The difficulty for corporate Australia is clear. If a company wants to restructure its affairs then it has to do so carefully or run the risk that the restructure might include, cause, or constitute an insolvency event.
If that were the case, then all of the company’s counterparties whose contracts include an ipso facto clause would instantly have a right to terminate; a potentially disastrous outcome.
For this reason, ipso facto clauses have attracted controversy. There is potential for them to have a chilling effect on entrepreneurship and business more generally.
From 1 July 2018, the Corporations Act 2001 was amended to, among other things, manage this risk.
Since 1 July 2018, the Corporations Act 2001 has included a regime that restricts the operation of ipso facto clauses.
Now – despite whatever a contract might say – a party to a contract entered into on or after 1 July 2018 will not be able to enforce an ipso facto clause to terminate a contract as a result of:
- The company entering into a compromise or arrangement with its members or creditors;
- A managing controller being appointed in respect of the whole or substantially the whole of the company’s property;
- The company’s financial position, if there is a managing controller of the whole or substantially the whole of the corporation’s property;
- The company being under administration; or
- The company’s financial position if it is under administration.
The time when the ipso facto right cannot be enforced, known as the “stay period”, is different for each of the relevant insolvency events. The stay period can be extended if the Court is satisfied that that an extension is appropriate in the interests of justice.
The stay period does not apply to liquidation. Any ipso facto clause relating to liquidation continues to operate despite the recent changes.
Parties cannot contract out of the new ipso facto regime.
Importantly, other “non-ipso facto” rights to terminate for reasons such as non-payment or non-performance are not affected.
What Should You Do?
The ipso facto amendments are young and contracting parties (and their lawyers) are still coming to grips with them.
Parties doing business under the new ipso facto regime should turn their minds to the following:
- The other side’s performance. Without the power of an ipso facto clause, a party who wishes to terminate will need other grounds to do so.
- Whether to try to negotiate an extension to existing “pre-ipso facto” contracts to preserve their operation.
- What measures might be included in the contract to protect business during a stay period. It may be that an obligation to make payments ought to be suspended for the duration of any stay period.
- Whether non-ipso facto termination clauses for matters like non-payment are adequate or require amplification.
- Whether a clause allowing for termination for convenience ought to be included in future contracts.
- Whether ipso facto clauses should be retained in future contracts, but expressed to be subject to the relevant provisions of the Corporations Act 2001.
- How improved pre-contract due diligence might be applied to reveal insolvency risks ahead of time.
- Whether obtaining guarantees from other parties, or obtaining bank guarantees, is appropriate or desirable.
While the right to terminate has certainly not been terminated, the recent ipso facto changes require businesses to reflect on how they manage their relationships in future.
If you would like to discuss your position under the ipso facto regime, and what strategy you should adopt to protect yourself, please don’t hesitate to get in touch.