Safe harbour and ipso facto insolvency reforms coming soon

By Jennifer Ball, Alex Schlosser

25 May 2017

Safe harbour and ipso facto clauses reforms are closer, with the consultation on the Insolvency Laws Amendment Bill 2017 having closed last week, but further work is needed.

The Federal Government's consultation on the safe harbour and ipso facto reforms in the draft Insolvency Laws Amendment Bill 2017 closed on 17 May 2017, so we now have a better idea of what they will look like.

The Bill seeks to provide a "safe harbour" for directors involved in any restructure, and also to prevent suppliers and third parties from exercising termination rights on voluntary administration or a scheme of arrangement using "ipso facto" causes.

If passed in its current form, the safe harbour reforms will take effect immediately upon Royal Assent, and the ipso facto reforms from 1 January 2018 (although anyone negotiating long-term contracts should start factoring the effect of the reform now).

Although the Bill is the result of a lengthy consultation and reform process, there are still some areas that require extra attention, particularly when it comes to the ipso facto reforms.

Background to the safe harbour reforms

The Federal Government announced in December 2015 that it would legislate to create a safe harbour; it released its Improving bankruptcy and Insolvency Laws Proposal paper on 29 April 2016.

On 28 March 2017, the Government released a draft legislation intended to reform Australia's insolvency laws, together with an accompanying explanatory statement for public consultation. (Clayton Utz made submissions to the Federal Government on the Bill).

The Government's view is that the amendments will drive cultural change amongst company directors to encourage them to maintain control of their company, engage early with possible insolvency and take reasonable risks to turnaround the company's business instead of placing the company prematurely into voluntary administration or liquidation.

What directors must consider when using the safe harbour

The amendments proposed in the Bill creating a "safe harbour" operate as a carve-out from the civil insolvent provisions at section 588G(2) of the Corporations Act, rather than operating as a defence. The provisions seek to provide protection outside of a formal insolvency practice to a director who, at the time when the debt is incurred, suspects the company may become or be insolvent and who then takes a course of action that might include a restructure of the business so as to allow it to trade out of difficulties.

Therefore, a director would only be liable for an insolvent company's debts where it can be shown that the director was not taking a course of action reasonably likely to lead to a better outcome for the company and its creditors, rather than the company entering into voluntary administration or liquidation.

There are some important matters that any director wishing to take advantage of the safe harbour must consider:

  • The new legislation avoids the use of indicia of reasonable grounds of solvency which often involves complex accounting or legal questions that may be beyond the personal expertise of directors such that a director would be required to have a "reasonable expectation" at the ability of the company to pay its debts as and when they fall due.
  • If a director suspects the company may become or be insolvent, he or she cannot afford to take a passive approach. Instead, he or she must engage early in a course of action, so they can assess whether that course is likely to lead to a better outcome for the company and its creditors.
  • Directors who want to invoke the safe harbour protection will need to ensure that appropriate steps have been taken for the company to comply with its obligations to maintain company books and records, provide for employee entitlements, and meet taxation reporting obligations.
  • Directors must closely and regularly monitor whether the company remains viable long-term and make any adjustments to the course of action to ensure that it is still reasonably likely to lead to a better outcome for the company and its creditors. If that is not possible, the directors must act to place the company into voluntary administration or take steps to wind it up.
  • As the safe harbour only applies to those debts incurred "in connection with the cause of action", it is imperative that directors assess at the time each debt is incurred what reasonable steps are being taken to restructure the business to allow it to trade out its difficulties, with ongoing monitoring and constant consideration of the company's financial position.

Ipso facto clause reform - are we there yet?

An "ipso facto" clause in a contract is a provision which allows one party to that contract to terminate (or to alter the terms of) the contract on the basis of the occurrence of a certain event relating to the creditworthiness of the counterparty to that contract (such as the insolvency of that counterparty).

While it is acknowledged that the right of a party to terminate on the occurrence of such an event is an important one, it does pose a serious impediment to the restructuring of companies that are in financial difficulties - particularly where the goodwill of the company is its main asset and is based on the continued operation of that contract (or series of contracts).

The insolvency regimes in number of jurisdictions, including the US, Canada and Great Britain, acknowledge this issue and apply a stay on enforcement of such termination rights, as a way of aiding the restructuring of companies under those regimes.

The second limb of the reforms in the Bill would introduce a similar regime on the stay of enforcement of ipso facto provisions into Australia's insolvency laws.

It should be noted that under the current proposals the stay on enforcement would apply only to entities entering into a scheme of arrangement or voluntary administration and, importantly, it would not apply to rights:

  • under contracts which are entered into after the date of the order approving the scheme or after the date that the administration begins (as applicable);
  • in a type of contract specified in the regulations or prescribed by ministerial determination;
  • which manage financial risk associated with a financial product which are commercially necessary for the provision of that type of product; or
  • which are declared as commercially necessary for a specific kind of contract by ministerial determination.

From a commercial perspective, the Bill has acknowledged that where a stay applies, the counterparty to the contract should not be obliged to provide further credit during the period its rights are stayed, and any obligation to provide further credit is unenforceable during that period.

While the introduction of a stay on enforcement in relation to ipso facto clauses is welcomed, we believe that further work is required in formulating a position that is workable under current Australian insolvency laws.

In our view:

  • further consideration should be given to other forms of "insolvency events", as we consider the application to schemes of arrangement and administration as being too narrow;
  • the stay on enforcement should not be limited in its duration but should be permanent (other than where the relevant company is wound up);
  • more work is required in specifying and regulating the types of arrangements that should be excluded from the automatic stay. At the moment only a general list has been provided; and
  • a specific exception should apply for secured lenders to a company that have security over all or substantially all of the assets of that company, as the acceleration of loans and enforcement of security in such instances is a fundamental tenet of secured lending transactions in Australia.

A start, not an end, to the safe harbour and ipso facto story

Given the lengthy consultation and reform process, it might seem perverse to say that the future shape of the law is settled. The unresolved issues in the ipso facto clause reforms, however, suggest that we will see further work done to ensure that the balance is struck between upholding commercial arrangements and preserving the value of a company that is a suitable candidate for restructuring.

Ultimately, as we argued last year in From Red to Black, legislative reform only provides a process for change. For restructurings to succeed, directors and management must also accept the cultural challenge of restructuring, involving as it does different communication and stakeholder engagement than exist in non-distressed situations.

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.