No more automatic right to terminate for insolvency

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By Andrew Wallis, Partner,  Andrew Chegwidden, Senior Associate, and Marcelle Chester, Lawyer.

How new insolvency reforms will affect your construction contracts

The Federal Government’s insolvency reforms contained in the Treasury Laws Amendment (2017 Enterprise Incentives No.2) Act 2017 (Cth) (the Act) commenced on Sunday, 1 July 2018. The key reform introduced by the Act will prevent a party from relying on a contractual right (for example a right to terminate) solely due to the insolvency of the counterparty. The aim of the Act is to help to de-stigmatise business failure and to encourage entrepreneurship by offering contractual protections to a party who is suffering financial or cashflow difficulties which may be temporary and capable of resolution.

The new insolvency regime applying to construction contracts

The Act applies to the majority of contracts entered into throughout Australia in both the public and private sectors (with some limited exceptions excluded by the Act, for example certain financial products).  In the construction sector, the Act will impact on common clauses within construction contracts which are known as “ipso facto clauses”. Ipso facto (meaning ‘by the fact itself’) clauses permit one party to terminate a contract or to pursue other specific remedies upon the occurrence of a specified event. In the construction industry, it is common for construction contracts to permit a party to terminate the contract if the counterparty becomes insolvent or goes into voluntary administration.

The need for reform

Ipso facto clauses which gave a party a right to terminate the other due to insolvency have garnered criticism for the harsh consequences which they can place on the counterparty in financial trouble, who otherwise may have been able to salvage its position by trading out of hardship or by undergoing a restructure.

The Act signals a shift in the government’s approach to companies facing insolvency, from the previously punitive approach to a more rehabilitative approach. The reforms also bring Australia in line with a number of other jurisdictions with similar insolvency provisions already in operation, such as the United States, Canada and Great Britain.

Operation of the new insolvency laws

Under the new provisions introduced by the Act, a party to a contract is unable to rely on ipso facto clauses if the reason for the reliance is that (amongst other things):

  1. the counterparty is entering receivership, administration or has proposed a scheme of arrangement; or
  2. a managing controller has been appointed over all or substantially all of the counterparty’s property.

The length of the period in which this rule applies will depend on the nature of the insolvency event. For example, for a voluntary administration, the rule will apply from when the company enters administration and will end when the company is wound up or when the administration ends.

Further benefits of the Act

The Act is aimed not only at preventing the counterparty from terminating the agreement in the case of an insolvency event, but also from preventing a party from enforcing other common clauses in construction contracts which:

  1. suspend the contractor from performing work;
  2. take work out of the contractor’s hands;
  3. set-off a party’s claims against the counterparty’s claims for payment; or
  4. regulate the call upon the security provided by the contractor under the contract, in all of the above cases if the right arises due to the insolvency of the counterparty.

Potential Risks to principals and main contractors

From the perspective of the party who is not insolvent and who is now unable to exercise a termination right on the occurrence of the counterparty’s insolvency for an extended period of time, the Act does raise potential concerns. For example, where a main contractor or subcontractor is insolvent, the principal or head contractor may suffer increased losses due to its inability to immediately terminate the contract and to promptly engage a replacement contractor to take over and continue the works.

This concern is further compounded in light of the practical reality which often exists on a project that involves an insolvent contractor, as a struggling contractor is typically more prone to “cut corners” in the performance of its works or to delay paying its subcontractors (often for months) before finally entering into voluntary administration. Whilst a principal (or head contractor as the case may be) may in such cases be able to terminate the counterparty pursuant to a fault-based termination process, such processes often require the non-insolvent party to incur additional delays whilst it follows the steps required by the termination clause, which typically involve the need to issue a notice to show cause and to consider and respond to the counterparty’s response to the notice to show cause, all of which can delay the appointment of a replacement contractor.

How this affects you as a participant in the construction industry?

Whether you are a principal or a main contractor on a building project, you will need to be aware of the restrictions on exercising contractual rights in the context of insolvency-related events.

When drafting and negotiating construction contracts, parties (and especially principals) would be wise to explore other contractual protections available to them to better insulate themselves against a potential insolvency of the counterparty. This can include measures such as ensuring that there is an unequivocal termination for convenience right in the contract[1], insisting on receiving parent company guarantees where available, insisting on the right to contact and make direct payments to subcontractors for work performed in favour of the main contractor, requiring increased levels of detail in the payment claim submission process (for example with respect to the evidence of payments made to subcontractors and evidence of the construction work performed), imposing tighter timeframes on the counterparty to respond to notices to show cause in the event of a default, and specifying an increased range of grounds on which a show cause notice can be issued. These steps can be in addition to obtaining reference checks on the counterparty such as third party financial reports and acting with greater scrutiny when reviewing any financial assessments of the counterparty.

 

[1] We note that there may be serious repercussions in the event that a party attempts to exercise a termination for convenience right if used in order to avoid the provisions of the Act. We recommend that specific legal advice be obtained prior to exercising a termination for convenience right in the event that the counterparty is insolvent at the time of the termination.

 

For further information, please do not hesitate to contact us.

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