Let’s Get Topical - Insolvency and Managing Contract Risk Part 2
22nd September 2020
You hear on the grapevine that a company that you have contracted with is “going under” and let’s face it, sadly a lot of businesses out there are doing just that during this COVID-19 pandemic. Quickly pulling the dusty contract out of your bottom drawer you flick through to the termination clauses and voila, there is a clause allowing you to terminate if the other party is insolvent. Great, time to pull the plug…but not so fast! Thanks to the Corporations Act 2001 (Cth) (“Corporations Law”) you may be doing so unlawfully.
What are ipso facto clauses?
A common term in any written contract is the ability to terminate the contract if the other party is insolvent. These are known as ‘ipso facto’ clauses (meaning by the fact or act itself). Typically, an ipso facto clause will allow one party to terminate the agreement if one of several insolvency events have occurred, these may include becoming subject to liquidation or winding up procedures or otherwise becoming insolvent (there’s usually a long list!).
Parts 5.1 and 5.2 of Chapter 5 of the Corporations Law imposes a stay (or pause) on the enforcement of your right to terminate a contract pursuant to an ipso facto clause in certain circumstances and applies to most contracts (there are exceptions). The rationale behind these provisions in the Corporations Law is to enable a company that may be in financial distress to salvage their situation, organise its affairs and have a chance to ‘trade out’ of their financial difficulties without actually going into liquidation.
You cannot contract out of these provisions, however, if the stay on the enforcement will cause undue hardship or potentially affect your own solvency status then you may be able to apply to the court to have the stay lifted. This neatly brings in to focus, the impact of COVID 19.
COVID 19 - Temporary relief for financially stressed businesses
Commonly, a creditor by issuing a statutory demand leads to a company entering into liquidation. However, in response to the current pandemic, the minimum threshold to issue a demand under the Corporations Law has increased from $2,000 to $20,000 and the time frame a company must respond has been extended from 21 days to 6 months. Directors also benefit from temporary relief from any personal liability for allowing a business to trade whilst insolvent. The federal government has recently announced that these temporary measures will remain until 31 December 2020 – a sign of tough times ahead.
Moving forward - manage your risk
If you are already a party to a contract, look to see if there are alternative basis upon which you can terminate. For example, is the other party in breach of another term of the contract? Sometimes that breach may not be obvious. Remember that not every breach of contract entitles you as the innocent party to terminate, so seek legal advice first.
If you are looking to sign on the dotted line, then do some basic due diligence:
carry out an ASIC historical company check which contains a credit rating;
search the court database for any recent/current disputes;
undertake a credit search using independent credit agencies such Dun and Bradstreet or Equifax; and
carry out a Person Property Security Register (PPSR for short) search to ascertain any current securities against the company and understand the level of risk.
Depending on the nature of the contract, consider stricter payment controls or step in rights. Consider entering into securities that may be registered on the PPSR to provide you with additional rights upon insolvency.
Remember that not every breach of contract entitles you as the innocent party to terminate, so seek advice first. Otherwise, you are at risk of unlawfully terminating the contract and potentially liable for a claim against you in damages.
Reliance on content the material distributed is general information only. The information supplied is not and is not intended to be, legal or other professional advice, nor should it be relied upon as such. You should seek legal or professional advice in relation to your specific situation.
About the Author
Phillipa Hooper is a Senior Associate at Active Law, ACS Queensland’s Preferred Legal Partner. Phillipa has over 20 years of local and international experience across a diverse range of legal areas including business and commercial law, property and construction. Phillipa can assist with structuring, business acquisitions/sales, loan agreements, mortgages, IP/trademark issues, governance, and a range of commercial contracts.
Active Law is ACS Queensland’s Preferred Legal Partner. ACS members receive a 10% discount on legal services up to the value of $2,000 and a 5% discount thereafter.